eas a a Fintreer- JuiceNotes 2022 Equity Investments | Fixed Income Derivatives | Alternative Investments Chartered Financial Analyst al Level!5 Ea ea Fintreex- Thank you for trusting us for your preparation for the CFA exam. We hope you enjoy the learning experience using the FinTree JuiceNotes. We are pleased to inform you that the printed version of JuiceNotes is now available on Amazon for a limited time. Our team has put in to bring out the very best of JuiceNotes to you, with glossy paper, multi-color flowcharts, and diagrams. We encourage you to get your copy of the JuiceNotes soon! Use the discount coupon FinTreeites below during your purchase. Try our printed JuiceNotes because we are sure you will be enamored by it. If you are not satisfied with the printed version of our JuiceNotes after receiving them, you may return it to us via Amazon. step 1 step 2 step 3 step 4 The cost of the printed JuiceNotes will be similar to printing them by yourself. 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Equity Investments Sr.No Name of Reading Page No. 33 |Market Organization And Structure 6 34 |Security Market Indices B 35 |Market Efficiency q7 36 | Overview of Equity Securities 20 37 Introduction to Industry And Company Analysis 24 38 |Equity Valuation: Concepts And Basic Tools 30 Fixed Income 39 | Fixed-Income Securities: Defining Elements 37 40 _| Fixed-Income Markets: Issuance, Trading And Funding 41 41 | Introduction To Fixed-Income Valuation 44 42__| Introduction To Asset-backed Securities 48 43 | Understanding Fixed-Income Risk And Return 52 44 | Fundamentals of Credit Analysis 57 Derivatives 45 | Derivative Markets and Instruments 62 46 | Basics of Derivative pricing and valuation 66 Alternative Investments 47 |Introduction to Alternative Investments 72OTA Aen Notice : Unless otherwise stated, copyright and all intellectual property rights in all the course material(s) provided, is the property of FinTree Education Private Limited, Any copying, Cece aun cun Cie a cea eee CR purpose provided shall tantamount to infringement and shall strongly defended and pursued, to the fullest extent permitted by law. 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Kindly get in touch with us at [email protected] for more details. indly refer wwwfintresindia.com for more‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Market Organization And Structure LOSa Main functions of financial system + To allow entities to save and borrow money, raise capital, manage risks and trade assets + To determine the returns where total supply of savings equals total demand for borrowing + Toallocate capital to its most efficient uses LOS b Classification of assets Oe erm => «x=» GID CID =D CID =D c=> ax + Equity securities - Represent ownership in a company + Debt securities (Fixed income securities) - Promise to repay borrowed funds + Publicly traded securities - Traded on exchanges or through securities dealers Private securities - Securities that are not traded publically. Often illiquid + + Derivatives - Value is derived from the value of underlying asset Financial derivatives - Underlying assets are equities, equity indexes, debt, debt indexes or other financial assets + Physical derivatives - Underlying assets are physical assets such as gold, oi + Classification of markets Ptr ear) Primary Carr fee fees t t Markets for longer- Market for debt term debt and securities with equity securities original maturities that have no ‘S1year specific maturity date Market for newly ‘Subsequent sales issued securities Markets for immediate delivery are referred to as spot marketsbtips:/iwww.fintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. LOS c Describe the major types of assets that trade in organized markets @ securities Intermediate ‘Common Preferred occ ¥ ’ ’ + + Maturity of Maturity Variable _Fixed dividend less than longer than lend Lor2 20 to 30 years and long-term years Last 2" preference Give the holder preference in incase of _ the right to buy Y + + case of iquidity and irm’s equity liquidity and dividend shares at a Notes Bonds dividend payment fixed price payment prior to the warrant’s expiration Commercial paper (firms), Bills (govt.), Certificates of deposit (banks) are all short term securities Pooled investment vehicles | stauat ons TFs and 11s cet aciet | Hedge funds + ’ + + Investors can Trade like closed- Represent a claim LLPs purchase shares end funds but have toa portion of a fromthe tunditself “apedialprovistons,——pooletmortgayes, —_Tnvestors- limited (open-end funds) allowing conversion car loans, credit partners or in the secondary into individual card debt etc. Fund manager - general market (closed-end portfc securities partner funds) ‘Sometimes referred Mutual Fund like to as depositories, structure for HNIs and their shares as depository receipts Use leverage, hold long and short positions, use derivatives and invest ® currencies + Issued by a government's central bank + Reserve currencies - Currencies held by governments and central banks worldwide. Primarily includes Dollar and Euro‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. ® contracts | t T t T 1 Forward Futures tion, Insurance (oat) (ame) (a | [memes] [ aa | ‘ + + + + Agreements to Used to hedge exchange a series] against Agreement to ‘of payments on unfavorable, buy or sell an Long Call - Right periodic unexpected asset in the ‘to buy settlement dates events. future at a price specified in the Similar to ‘Short Call - Currency swap - Eg. Life contract at forward contracts | Obligation to sell Loan in one insurance, P&C inception ‘except that they currency for the | | insurance etc. are standardized Long Put - Right loan of another Eg. Agreement and exchange to sell currency Credit default to buy 200 Ibs of traded swaps (CDS) are wheat 60 days Short Put - Equity swap - a form of from now for Obligation to buy Exchange of insurance that $800 return on an makes a equity index for payment if an interest payment issuer defaults on debt ‘on its bonds @ commodities + They trade in spot, forward and futures market + Include precious metals, industrial metals, agricultural products, energy products, and credits for carbon reduction @ Real assets + Real assets include real estate, equipment, machinery etc. + Buying real assets directly often provides income, tax advantages, and diversification benefits + Heterogeneous in nature, they require to do substantial due diligence before investing + Rather than buying real assets directly, an investor can make investment in REIT (high dividend payouts and tax advantage) or master limited partnership (MLP) or buy the stock of firms that have large ownership of real assets LoS d Types of financial intermediaries and their services Brokers, exchanges and alternative trading systems connect buyers and sellers of the same security Pe ee eau Dee eee eee ee eee ee ay err Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues Securitizers and depository institutions package assets into a diversified pool and sell interests Insurance companies manage the risk inherent in providing insurance Clearinghouses reduce counterparty risk and promote market integrity Pe eee ne te ATS - Do not reveal current client orders as dark pool. Aka ECNs/MTFs. No regulatory functionhttps:www.fintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. LOSe Positions an investor can take in an asset Long position - Represents current or future ownership Long benefits when the asset value increases Short position - Represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it(short sale) Short benefits when the asset value decreases Leveraged position - When an investor buys a security by borrowing from a broker, the investor is said to buy on margin and has a leveraged position Sf Leverage ratio, rate of return on a margin transaction and margin call price Eg. S,=100 S,=120 Initial margin(IM) = 40% Maintenance margin (MM) = 20% Leverage ratio- SE or pening price * Ag = as margintransecton= ici = 220-400. 20. gong Margin cal price -S. (=er) = 75 LOS g,h Execution, validity, and clearing instructions Bid price - Price at which dealer buys a security Ask price - Price at which dealer sells a security Traders who post bids and offers are said to make a market Those who trade with them at posted prices are said to take the market Execution Market order- + It instructs the broker to execute the trade immediately instructions at the best possible price + Appropriate when the trader wants to execute quickly + Disadvantage - Orders may execute at unfavorable prices Limi z order- + Used to avoid price execution uncertainty + Disadvantage - Order might not be filled Ask Price | Qy | Price | Qy $51.5 Aggressively priced $51 Taking the market $50 Making a new market $49 Making a market 48 200 52 200 $48 behind the market 7 500 53 700 49 | 100 | 51 | 300 Limit orders waiting to execute are called standing limit orders Limit buy order with a price considerably lower than the best bid, or a limit sell order with a price significantly higher than the best ask, is said to be far from the markethips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. + All-or-nothing orders - Execute only if the whole order can be filled iden orders - Only the broker or exchange knows the trade size + Iceberg orders- Some of the trade is visible to the market, but the rest is not ® Validity instructions + Specify when an order should be executed + Day orders - They expire if unfilled by the end of the trading day + Good-till-cancelled - They last until they are filled + Immediate-or-cancel (Fill-or-kill) - They are cancelled unless they can be filled immediately + Good-on-close - They are only filled at the end of the trading day. If they are market orders, they are referred to as market-on-close orders. + Stop loss sell order - Stop (trigger) below the current market price (executed on a downside only) + Stop loss buy order - Stop (trigger) above the current market price (order placed to protect short Position) Price Price 100 > 80 30 ‘Time ‘Time Stop loss sell order Stop loss buy order @ Clearing instructions + Tell the trader how to clear and settle a trade + Retail trades - Settled by the broker + Institutional trades - Settled by a custodian or another broker LOSi Primary and secondary markets Primary markets Secondary markets Sale of newly issued securities Securities trade after their initial issuance Seasoned offerings(secondary issues) - Shares issued by firms whose shares are currently trading in the market Initial public offerings (IPOs) - Shares issued by firms whose shares are not currently publicly traded 10hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. + Book building - Process of gathering indications of interest + Indications of interest - Investors who agree to buy part of the issue + Underwritten offering - Investment bank agrees to purchase the entire issue at a price that is negotiated between the issuer and bank. It must buy the unsold portion of the issue + Best efforts offering - Investment bank makes ‘best efforts’ to sell the issue but is not obliged to buy the unsold portion Tee te i coke + As issuer's agents, investment banks should set high price to raise the most funds for the issuer but as underwriters, they prefer to set the price low to sell the whole issue Pe ra br CeCe cy + Private placement- Securities are sold directly to qualified investors(substantial wealth and investment knowledge) + Shelf registration- Firm makes its public disclosures as in a regular offering but then issues the registered securities over time when it needs capital + Dividend reinvestment plan (DRIP/DRP) - Allows existing shareholders to use their dividends to buy new shares from the firm at a discount + Rights offering- Existing shareholders are given the right to buy new shares at a discount. Because of rights offering shareholders’ ownership is diluted unless they exercise their rights Importance of secondary market They provide liquidity They provide price/value information Better the secondary market, easier it is for firms to raise capital in the primary market LOSj Quote-driven, order-driven and brokered markets Call markets Secu They are liqu Used in smaller markets but is also used to set opening prices on major exchanges s are only traded at spé when in session but Continuous markets Securities are traded at any time when the market is open -ask quotes Price is set by either auction or by dealer "1hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. + Order matching rules: + Order precedence hierarchy + Determines which order goes first + The first rule is price priority + Secondary precedence rules determine how to rank orders at the same price + Trade pricing rule - After the orders are matched, the trading system then uses its trade pri to determine the trade price + Uniform pricing rule - Call markets . iminatory pricing rule - Continuous trading markets + Derivatives pricing rule - Crossing network where they match buyers and sellers who are willing to trade of prices obtained from other markets ing rule + Pre-trade transparent market - Investors obtain pre-trade information regarding quotes & orders +. Post-trade transparent market - Investors obtain post-trade information regarding completed trade prices and sizes + Dealers prefer opaque markets. Transactions costs and bid-ask spreads are larger in opaque markets LOSk Characteri: of a well-functioning financial system Complete markets- Savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can obtain needed assets Operational efficiency- Trading costs are low Informational efficiency- Prices reflect fundamental information quickly Allocational efficiency - In informationally efficient markets capital is directed to its most productive use LOSI Objectives of market regulation tioat urease ees ue cay Pen aru ue eau kg Promote common financial reporting requirements so that information gathering is less expensive Seu eke eee Cu a ee) ear a ‘All querias/doubts about this reading can be posted on FinTree Forum for the reading 12‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Security Market Indices LOSa What is a security market index ? > Used to represent the performance of an asset class, security market, or segment of a market > An index is a hypothetical portfolio LOS b Price return and total return of an index Price return _ Price index - Uses only the prices of the constituent secut ies Rate of return that is based on a price index is referred to as price return Total return Return index - Uses both prices and income of the constituent securities Rate of return that is based on a return index is referred to as price return LOS c¢ Choices and issues in index construction and management st ey + Securities to be include from the target market + Appropriate weighting method See eee en eared Se oa ae ae eo au Ree aor eet LOS d&e Different weighting methods used in index construction Price Equal ee Fundamental Totaits Sorina . eigntet Seta ferantes Sora Brera ee te Uses weights based Care ta on firm fundamentals return or total return Bees dividends or cash flow| Can be based ona Sees Cd Peery 13-https:l/www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Eg. Constituent P,P, -- DPS, Quantity %AP = %AP_ Market ~— Market Dividend securities with DPS cap, cap, A soo | 140 | 5 | 10,000 | 40% 45% | 1,000,000 | 1,400,000 | 50,000 B 120 | 80 | 6 | 20,000 | (33.33%) | (28.33%) | 2,400,000 } 1,600,000 | 120,000 c 140 | is4 [0 | 5,000 10% 10% 700,000 | 770,000 0 D 160 | 176 [ 0 | 15,000 | 10% 10% | 2,400,000 | 2,640,000 0 Average/ | 130 | 137.5] 2.75 6.667% | 9.1675% | 6,500,000 | 6,410,000 | 170,000 otal eee Cee Cee ret aay (Avg. of % A Pr OKT) Cerne Ceteae Oe ERENT ewe ee CTT) 7 (Avg. of % AP with DPS) 137.5 42.75 _4 FET) + Price weighted index - Equal number of shares in each of constituent stocks + Equal weighted index - Equal amount of shares in each of constituent stocks + Market cap weighted index - Proportion of market + In price-weighted index, denominator must be adjusted for stock splits + Equal weighted portfolio requires most frequent rebalancing (adjusting periodically) + Market capitalization-weighted index is also known as value-weighted index + Itcan be adjusted for a security's market float (excluding shares held by controlling shareholders) or free float (Market float ~ shares not available for foreign buyers) 2 Rebalancing and reconstitution of an index Rebalancing Adjusting weights of securities in portfolio to their target weights after weights are changed due to changes in price Usually done quarterly Reconstitution Adding or deleting securities that are included in an index The price of security added to an index increases and the price of security deleted from an index decreases ix E a Uses of security market indices Reflection of market sentiment Benchmark of manager performance Measure of market return Measure of beta and excess return Model portfolio for index funds ++ tet 14beips:/iwww.fintreeindia.com! © 2022 FinTree Education Pvt. Ltd. LOSh ‘Types of equity indices errs rns | | ed | | LOSi ‘Types of fixed-income indices + Fixed income indexes can be classified by issuer, collateral, coupon, maturity, default k and inflation protection + Fixed income security universe is much broader than the equity universe + Since fixed income securities mature, they must be replaced in fixed income indexes. As a result, fixed income indexes have a high turnover + Fixed income securities are primarily traded by dealers, so index providers have to depend on dealers for recent prices LOSj Indices representing alternative investments Commodity Real estate Hedge fund indexes _ indexes indexes 1 1 \ ‘Can be based on Equally weighted appraisals of indexes properties, repeat, futures not Property sales or Exhibit upward ‘spot prices the performance {survivorship bias| of REITs P Appraisal - It means valuation. They provide a smoothing effect and they result in lower SD Some indexes could be Hedonic which means constructing indexes after adjusting for quality 15hips:/iwww.fintreeindia.com/ LOSk Types of security marke (rus ie onto Lee Sector/industry - Eg. indexes of pharmaceuticals producers Level of economic development - Eg. emerging market indexes Fundamental factors - Eg. indexes of value stocks or growth stocks ueries/doubts about this reacing can be posted on Wiesubietorowabee ‘All quores/doubts about ths reading can be posted: testable concepts here arma mPa Te Video Link (© 2022 FinTree Education Pvt. Ltd. 16(© 2022 FinTree Education Pvt. Ltd. Market Efficiency Market efficiency and related concepts btips:/iwww.fintreeindia.com! LOSa Informationally efficient capital market All information available about a security is reflected fully, quickly, and rationally in its current price In a perfectly efficient market, investors should use passive investment strategy (investing in indexes) because active investment strategies will underperform due to transactions costs and management fees Market's efficiency can be determined by the time taken for information to reflect in the price of the security Market prices are not affected by the release of information that is well anticipated. ‘Only new information that is unexpected causes changes in prices In efficient markets, market value is same as intrinsic value, thus expected return ‘would be equal to required return LOSb eee ees Value that a rational investor would willingly pay Current price of the asset Can't be known with certainty Can be known with certainty Changes constantly as new information becomes available, LOS ¢ Factors that affect market efficiency Market partic Availability of information ants. Impediments to arbitrage Short selling Transaction and information costs More the market participants, more efficient the market More information available to investors, more efficient the market Limit arbitrage activity and allow some price inefficiencies to persist Improves market efficiency. Restrictions on short selling reduces market efficiency If information cost > potential profit, market prices will be inefficient LOS d&e Type of market Price reflects __| What is preferred? | What does not work? Weak form > Fundamental (active portfolio | Price and volume | analysis Technical analysi management) +_Insider trading + Technical analysis 2 cee rtoonnte,, | Insider trading | Fundamental management) analysi Strong form |. Price and volume 1 Fechinical analysis (passive portfolio | Public info. Nothing management) |- Private information + Insider trading 17btips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSf Market anomalies Market anomaly - Something that deviates from the efficient market hypothesis Cross-sectional data Anomalies ‘Overreaction) anomalies r January effect or turn-of-the-year Firms with poor High short-term ‘Small-cap stocks | Value stocks effect stock returns over| | returns are ‘outperform outperform previous 3 to 5 followed by | | large-cap stocks | | growth stocks For first five | | years have better| | continued high | | days of January, ‘subsequent returns Violates semi- Violates semi- stock returns for return strong form of strong form of ‘small firms are market efficiency | market efficiency ignificantly Violate weak form) Violate weak form) because because igher than they of market of market information is information is are for the rest | lefficiency because) efficiency because! | publicly available | | publicly available of the year profitable profitable strategy is based | | strategyisbased|| + pye, > p/p L P/E, | P/B Reasons -tax- | | “only on market | | only on market | | ividend "} Dividend loss selling and data data jindow dressing u CO J Other anomalies + Closed-end investment funds trading at large discount to NAV + Slow adjustments to earnings surprises + IPOs are typically underpriced, but long-term performance of IPO shares as a group is below average suggesting investors overreact (too optimistic about a firm's prospects on the offer day) + According to research, stock returns are related to known economic fundamentals such as dividend yields, but relationship between them is not consistent over all time periods 18‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOS g Behavioral finance SLO Coosa Ni Coo Oe ae ec ae ee Re ed of others and not evaluate risk in the way traditional models assume they do Mee ed Loss aversion (dislikes risk) [Losses are twice as powerful (psychologically) as gains] eee Oe ur ae eur ets) Ce QC Lae) Information cascade (investors mimic the decisions of others) Conservatism (Investors tend to be slow to react to new information) Narrow family (Focus on issues in isolation) ‘All queries/doubts about this reading can be posted on Watch video with important FinTree Forum forthe reading testable concepts here 19bips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Overview of Equity Securities LOSa Characteristics of type @ common shares s of equity securities > Most common form of equity > Capital appreciation > Variable dividend (no obligation to pay) > Dividend is a function of profitability > Last preference in case of liquidity and dividend payment Voting system ai kOxtigns a = Callable common shares are more riskier than putable common shares ® Preference shares Features of both common stock and debt Usually do not mature Can have call or put features just like common stock or debt yuu Do not have voting rights v Fixed dividend (no obligation to pay) > Dividend is a function of profitability > 2™ preference in case of Ii ity and dividend payment Based on accumulation Based on receipt of Based on of dividend _extradividend dividend conversion —_—J -—— 20https:/www.fintreeindia.com/ © 2022 FinTree Ede LOS b Ownership characteristics among different equity classes Pvt. Ltd. PT EOC ten oe and Class B shares Bo ee A i Cee eu ace iquidation. They may also be treated with different dividends, stock splits etc. formation can be found in the company’s filings with securities regulators LOS c¢ Private equity compared to public equity Usually issued to institutional investors Less liquidity Direct negotiation between the firm and its investors Limited financial disclosure Lower reporting costs Potentially weaker corporate governance Greater ability to focus on long-term prospects Potentially greater return YEH OD Main types - VCs, LBOs, MBOs, PIPE LOS d Methods for investing in foreign equity securities Integrated markets - Capital flows freely across borders Obstacles to direct Investment and return are denominated foreign investment - _in foreign currency Foreign stock exchange may be illiqui Reporting requirements may be less strict Investors must be familiar with the regulations Depository receipts (DRs) Global depository Issued outside US and outside Represent ownership in a foreign firm receipts (GDRs) the issuer’s home country Traded in the markets of other countries in local market currencies American depository Denominated in USD and are Bank deposits shares of the foreign firm receipts (ADRs) traded on U.S. exchanges and then issues receipts representing ownership of foreign shares Global registered Trade in different currencies If the firm is involved with the issue, it is a shares (GRS) on stock exchanges around ‘sponsored DR or it is an unsponsored DR ‘the world y y Basket of listed 1 an ETF that is a collection depository receipts Gf prs Investor has Bank has voting (BLDR) voting rights rights 2https:/www.fintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. ‘Types of ADRs Level 1 Level 2 Level 3 Rule 1448 Trading location | OTC | NYSE, NASDAQ | NYSE, NASDAQ | Private and AMEX and AMEX ‘SEC registration | Yes Yes Yes No required Ability to raise No No Yes Yes capital in US Low High Low LOSe Risk and return characteristics of equity securities Returns consist of dividends, capital gains/losses from changes in share prices, and foreign exchange gains or losses if any Common measure of risk for equity securities is standard deviation Putable shares - Least risky Callable shares - Most risky Cumulative preferred shares - Less risky - Lower dividend yield Non-cumulative preferred shares - More risky - Higher dividend yield LOS£ _ Role of equity securities in the financing of a company’s assets Prt nn nee nr renner Cee ee cd Used to offer to employees as compensation Share price x No. of shares Reflects investors’ expectations about timing, __decisions and operating amount and risk of firm's. _results since its inception future cash flows Increases when firm has positive net income 22bups:/iwww.fintreeindia.com! © 2022 FinTree Education Pvt. Ltd. ‘All quories/doubts about this reading can be posted on Watch video with important nTree Forum for the reading testable concepts here Video Link 23‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Introduction to Industry And Company Analysis LOS a Uses of industry analysis + Provides a framework for understanding the firm + Can provide information about the firm's potential growth, competition, risks, appropriate debt levels and credit risk + Industry rotation - It means overweighing or underweighing the industries based on the current phase of the business cycle + Performance attribution analysis - The sources of portfolio return are determined relative to a benchmark LOS b Ways to group companies and industry classification systems Pe aa ay Dee eee eee ee Cie kk ues statistical methods such as cluster analysis Sector - Group of similar industries ens uy Ca a Reese a) (COR eet cue Ciog Creag] Cees Ronee ttc N ELC Cera) pO ere ee arc a) Dow Jones and FTSE [4 tier classification] Pee eter ed Sec ba eacl Classification (ISIC) - United Nations ee eek et pUr etree nue ra Re uraeub rte ment GCM ue ad Commercial classification Identifies the constituent firms Updated frequently Includes for-profit and public firms Government classification Do not identify constituent firms Updated less frequently inguish b/w small or large firms, profit or not-for-profit firms, or private or public firms 24bhps:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOS c¢ > Earnings are less dependent on business > Earnings are highly dependent on business cre) crcl > Can be further separated into defensive Piinivenienepartna everore (Stable) or growth industries > Their products are often expensive, non- > Defensive’ least affected by business cycle necessities whose purchase can be delayed 5 Growth - Demand is strong. Largely a unaffected by business cycle ‘> Sectors - Energy, Financials, Technology sg ctors - FMCG, Healthcare, Utilities, Consumer staples LOSd Peer group __ It consists of companies with similar business activities, demand drivers, cost structure drivers and availability of capital LOS e Elements needed to be covered in thorough industry analysis Evaluate the relationships between macroeconomic variables and industry trends les using different approaches and scenarios Check estimates against those from other analysts ‘Compare the valuation for different industries ‘Compare the valuation for industries across time to determine risk and rotation strategies Analyze industry prospects based on strategic groups Classify industries by their life-cycle stage Position the industry on the experience curve Consider demographic, macroeconomic, governmental, s Examine the forces that determine industry competition tee etetete Experience curve - It shows cost per unit relative to output ‘The curve declines because of increase in productivity and economies of scale, especially in industries with high fixed costs LOSf Porter’s five forces 44, Crna ben tae Sori Beret ccd Cenc ee cd 25butpsil/wwwfintrecin LOS g Pareency tag Cee] Peet et prevent new Coe PC EOE pi Dc ay etc Sar) Perea) Industry concentra pra eee rd Dg eee ar fos Oru a) Pi omaaeas en Deh] ocd Da Cura) ern) Cecio ctor] (© 2022 FinTree Education Pvt. Ltd. rag Crd CToaules eeu Cel i Peet od Peet Fee re it results in pricing wars} ea Pasir kcurcy co na) Deeg can be reallocated more| cre rant) ed Market share Baa DT Rd estar ag Cea eet Teta etd ua kere (eet ret ed eure) eur products to another Dr cae ra Deeg Peau rcg 26bhtips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSh Industry life eycle Demand Mature Decli Shakeout, seating Growth Embryonic Time r rc Embryonic | | Growthstage| | Shakeout Mature stage | | Decline stage stage stage Slow growth - Rapid growth - Slowing growth - ‘Slow growth - Negative growth - Customers are New consumers: Demand reaches Saturation of Due to substitutes, unfamiliar with the discover the saturation level market. Demand societal changes or product product with few new only for global competition customers replacement High prices - ittle competition - Declining prices - Volume required ‘Threat of new Intense Consolidation - Intense for economies of entrants but firms competition - Market evolves: scale isnotyet still grow without Industry growth to anooligopoly_price wars due to reached Large investment - To develop the product High risk - Most embryonic firms fail competing on price Falling prices - Economies of scale are reached and distribution channels increase Increasing Profitability - Due to economies of scale gets slowed. So firm growth comes High barriers to at the expense entry - of competitors ms have brand loyalty and low Industry cost structures ‘overcapacity - Supply > demand Declining avoid price wars. profitability - Periodic price Due to wars may occur ‘overcapacity during recession Cost cutting - Firms restructure to survive and try to build brand Firms with better loyalty products may row faster than Increased fai industry average liquidate or are acquired overcapacity Consolidation - 27bps:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSi Elements of industry strategic analysis > Major firms > Industry stability > Government influence > Barriers to entry and success > Life cycle > Social influence > Industry concentration > Competi > Technological influence > Influence of industry capacity on pricing | > Demographi > Business cycle sensitivity LOSj External influences on industry growth, profitability and risk | T T T T 1 Macroeconomi | | Technological I Demographic | Governmental I Social Can be cyclical or “Includes tax rates) Relate to how structural regulations, people work, play, Technology can Includes size and | | empowerment of | | SPend their money| Include long-term dramatically age distribution of | self-regulatory and conduct their trends in factors change an ‘the population ‘organizations, lives such as GDP industry through and government growth, interest | |the introduction of | Eg. Aging of the purchases of Eg. When women rates, inflation overall population goods and ‘Started getting and credit can mean services Jobs, restaurant availal ificant growth industry Eg. Computer for the health care Eg. Ban on benefitted hardware industry ‘tobacco because there was; madecsen Tess cooking at home Losk Elements that should be covered in a thorough company analysis Competitive strategy - How firms responds to opportunities and threats Cost leadership - Low cost, low price, superior return Used to protect market share (defensive) or to gain market share (offensive) Product differentiation - Firm's products/services are distinctive terms of type, quality or delivery 28hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. ‘Company analysis involves analyzing firm’s financial condition, products and services, and competitive strategy. It includes following elements aad pr enter cus id tet ore) ee tetai sy Ces sce Lite Gosche inet ea SLA MS RUA oa caad Predatory pricing - The firm hopes to drive out the competition and later increase prices Spreadsheet modeling - Used to analyze and forecast company fundamentals Model's complexity can make their conclusions seem precise ‘All queties/doubts about this reading can be posted on Witch video with important ‘inTree Forum forthe reading ‘stable concepts here 29btips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Equity Valuation: Concepts And Basic Tools LOSa__ Determine whether stocks are overvalued, undervalued, or fairly valued Fairly valued - Market price = Intrinsic value Undervalued - Market value < Intrinsic value Overvalued - Market value > Intrinsic value For security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over time More investors after a security, more likely it is to be fairly valued LOSb Major categories of equity valuation models Discounted cash flow model Asset-based model (Present value model) (Market multiple models) t ‘ ’ Value is estimated as PV of Ratio of stock price to Total Assets ~ Total Lial cash distributed to fundamentals (earnings, No of shares shareholders (DDM) or PVof —_ sales, BV, CF etc.) Eg. P/E cash available to shareholders ratio after fixed and working capital expenses (FCFE) Ratio of Enterprise Value (EV) to EBITDA or sales LOS c Cash dividends ee ( Regular) (— Special dividend dividend Paid at regular xtra/irregular intervals e9. dividend ‘quarterly ) L The payment of dividends is not a legal obligation 30butps:/wwwfintrecindia.com! © 2022 Fin'Tree Education Pvt Lid, Share repurchase Coie tec Repurchased shares are not considered for dividends, voting or computing EPS. Equivalent to cash dividend SR ct) Gea Re a er Tax efficiency in markets where tax rates on dividends are more than tax rates on capital gains Ability to absorb increases in outstanding shares because of the exercise of ESOPs Los d Dividend payment chronology Declaration Cum-dividend Ex-dividend Holder of Payment date date date record date date Feb.24 Mar. 13 Mar. 14 Mar. 16 Mar. 31 Settlement cycle in US = T +3 If a person buys shares on or after ex-dividend date, he will not receive the dividend LOSe Describe DDM & FCFE @ vpm one-year hoking period DOM = re Pic + ry Pic = — D, P, Two-year holding period DOM = Pip + GPK t GSK) 15 P,=21 D,= 1.5 Expected dividend growth = 5% Required rate of return = 13.5% / x D, _ 45x (1 +0.05) 15750 _ One-year holding period DDM= Pics = “GY oaaSyT ~ Tagey = 139 + P, 15 15 T+Ky ~ ‘1 + 0.135) = (ris) = 33.215 14.605, = 1.575. 1.39 - it it = D, 1.5 x (1 + 0.05) . Tworyear holding period DDM= ERY = “+ 0.235) Tiss) * + 2 D, | ASx(1+0.057 _ 165° _ GK = “Grorssy = 2a) = 178 + _», 21 24 T+Ky = I+ 0.135)" = (rzeay = 16.3 18.97 31‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. @ rcrr 1 t T T 1 Pca} CE PEELE Pe koa) CFO Net income EBIT x (1- t) EBITDA x (1- t) + Interest x (1 - t) + Non cash charges + Depreciation x t + Interest x (1 - t) + Non cash charges WC investment + Non cash charges + FC investment + WC investment + FC investment + WC investment + FC investment + FC investment FCFE = FCFF ~ Interest (1 — t) + Net borrowings Losf Intrinsic value of non-callable, non-convertible preferred stock Dividend idend , Face value Value like a fixed K ‘coupon bond Value (Perpetuity) = Value (Finite maturity) = LOS g Gordon growth model ee ar eu CO) cs Dei rs eens SO UN AC anu Ud (g = ROE x Retention ratio) To keep ROE constant capital structure : Cheadle unc unc nae Ben oe cer) Deu eur Eg. Expected idend growth (For 4 years) = 20% Expected dividend growth (after 4 years) = 5% D,=2 K,=13% Calculate the value of stock D.= Given = 2 D.= 2x (1+0.2)'= 24 D,= 2x (1+0.2)'= 2.88 D,= 2x (1+0.2)'= 3.456 D.= 2x (1+0.2)'= 4.1472 D,= 4.1472 x (1 + 0.05) = 4.3546 = —43546 0.13 - 0.05 3.456 , 54.43 44.1472 _ + at + oe 427 = 54.43 Value of stock - 32hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOS h Appropriateness of constant growth and multistage dividend discount model + Constant growth model - Firms that pay dividends that grow at a constant rate (stable/mature firms or noncyclical firms) + 2-stage DDM - Firm with high current growth that will drop to a stable rate in the future (firm experiencing temporary high growth phase) + 3-stage DDM - Young firm that is still in its high growth phase LOSi&j Valuation based on multiples Price-Earning multiple (P/E) SR Based on MPS Based on fundamentals (justified) Leading P/E-MPS/EPS P/S-MPS/Sales per share _P/B- MPS/BVPS LOSk Enterprise value Eg. MV of debt = $700,000 MV of preferred stock = $500,000 No of shares = 9000 Market price per share = 100 Cash = $400,000 Short term investments = $200,000 MPS x No. of shares 900,000 Given 700,000 MV of preferred stock - Given 500,000 (Cash) Given (400,000) (Short term investments) Given (500,000) Enterprise value $1,200,000 33hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOS1 Asset-based valuation models Equity value = MV of Assets — MV of Liabilities Appropriate for a firm whose assets are largely tangible and have fair values that can be established easily LOS m and disadvantages of each category of valuation model DCF (PV) model Multiplier model Asset-based models Advantages | Disadvantages Advantages | Disdvantages Disdvantages + mvs are dificult + Sensitiveto | to obtain inputs + Inaccurate when + Negative + Can provide firm has a large + Inputs must be denominator floor values ‘mount of + Easyto caleulate|| "estimated resultsn | intangible assets meaningless + Useful for or fucire CFs not + Widely accepted|| + Estimates are ratio (P/E) valuing pubic || fenacted in asset ‘very sensitive to. time series and | + May not be | firms that report || Value input values. ‘cross-sectional comparable | fair values (MV) || |. Difficult to value comparisons across firms, during especially hyperinflation internationally [A queries/ doubts about this reading can be posted on FinTree Forum for the rei Wath video with important ‘ideo Link 34Fixed Income Notice : Unless otherwise stated, copyright and all intellectual property rights in all the course material(s) provided, is the property of FinTree Education Private Limited, Any copying, Cece aun cun Cie a cea eee CR purpose provided shall tantamount to infringement and shall strongly defended and pursued, to the fullest extent permitted by law. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute code of Ethics. Your assistance in pursuing potential violators of this law is greatly PCCM RCN CR mum anc Onn ig Pec) We have concealed a user specific code within this material to identify the original user. In case of violation of copyright laws, duplication or mass circulation of this material, the original user to whom this material was issued will be identified and pursued under appropriate laws, Further, the user indetification will also be reported to CFA Institute.A CommuterNotes™ Anormal person spends about two-three hours travelling every day — going to work, walking down the street to buy stuff or just going for a walk. Wondering how to utilize this travel time? The geeks at FinTree have the perfect solution for you! FinTree's Commuter Notes! Helping you study when you can't! Commuter Notes are short audio clips that can be downloaded on any smart phone. These audios are an interaction between the faculty and 2-3 candidates discussing a topic and will help you learn subconsciously!hps:/iwww.fintreeindia.com/ Fixed-income © 2022 FinTree Education Pvt. Ltd. Securities: Defining Elements LOSa Basic features of a fixed-income security Issuers of bonds Supranational entities - Issued by organizations that operate globally. Eg. World Bank, IMF etc. Sovereign governments (national) - Issued by national government entities. Eg. US T-bills Nonsovereign governments (local) - Issued by non national government entities. Eg. C state bonds Quasi-government entities - Agencies that are owned and sponsored by governments. Eg. postal services Corporations - Financial companies & nonfinancial companies Bond maturity Perpetual bonds - No maturity. Make perio payments but do not promise to repay the principal Original maturity < 1 Yr - Money market securities Original maturity > 1 Yr - Capital market securities Tenor - Time remaining until maturity Par value Also referred to as the face value/maturity value/redemption value/principal value Bond price < Par value - Trading at Bond price > Par value - Trading at premium, jiscount Coupon payments Coupon is always calculated on Par value Payments could be annual, semi-annual, quarterly or monthly Zero coupon bonds - Make no interest payments. Bonds are issued at discount and redeemed at par Currencies Dual-currency bond - Coupon payment in one currency and principal repayment in another Currency option bond - Bondholder has a choice of two currencies LOSb Bond issuer (borrower) Content of bond indenture © Bond investor — t (lender) Legal contract, (known as bond indenture) It defines obligations of and restrictions on the borrower Covenants - Provisions in the bond indenture LOSc 37htips:/iwww.fintreeindia.com/ LOS d © 2022 FinTree Education Pvt. Ltd. Considerations that affect the issuance and trading of fixed-income securities Types of bonds nn Domestic bonds 4 Foreign bonds Eurobonds Global bonds t t 4 Bonds issued by entities that are incorporated in that country Bonds issued Bonds issued by Bonds that are simultaneously entities that are ued and on the Eurobond incorporated in traded on the market and in at another country Eurobond market least one domestic market - Government, corporations etc. Securitized bonds - Bonds issued by special purpose entities (SPEs) Sources of Repayment - Sovereign bonds - Repaid by the tax receipts of the 1g country. Nonsovereign government bonds - Repaid by general taxes, revenues of a specific project or fees dedicated to bond repayment Corporate bonds - Repaid from cash generated by the firm’s operations Collateral and Credit Enhancements - Unsecured bonds (debentures) - Represent a claim to overall assets and cash flows of the issuer Secured bonds - Backed by a claim to specific assets. Reduces default risk. They are senior to unsecured bonds Equipment trust certificate - Backed by equipment such as railroad cars Collateral trust bonds - Backed by financial assets Collateral - Those specific assets used in issuing secured bonds company 38‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Credit enhancement External Overcollateralization Ca8h reserve Excess spread fund account + + t Collateral Cash is set Yield on ABS < pledged > Par | | aside to make Yield on value of debt up for credit underlying Tranches issued losses asset Surety bonds Bank guarantee Letter of credit + + + Issued by an insurance Promise to lend money companies. They make Same as surety bonds lend m up any shortfall in the but issued by a bank Baythe issuer if cash to service the debt, necessary Taxation - Interest income - Taxed at the same rate as ordinary income. For municipal bonds is usually tax-exempt Capital gains - Taxed at capital gains tax rate LOSe Structure of CFs of fixed income securities Typical bond Bullet structure - Periodic interest payments and principal value at maturity ‘structure - Balloon payment - Final interest payment + Principal at maturity Amortizing structure - Part of principal is paid at each payment date Fully amortizing structure - Equal payments Partially amortizing structure - Balloon payment of ing principal at maturity ing fund provision - specified times Floating-rate notes Their interest rate is dependant on market rate (reference rate) FRN coupon = Reference rate (LIBOR) + margin Variable-rate note - Margin is not fixed Interest rate cap - Limit on how high the coupon rate can rise Benefits the issuer (borrower) Interest rate floor - Minimum rate that investor receives Benefits the lender (investor) Inverse floater(FRN) - Coupon rate # when reference rate # 39bttps:/iwww-fintreeindia.com © 2022 FinTree Education Pvt. Ltd. ‘Other coupon structures Coupon rate increases over time according to a predetermined schedule If credit quality # Coupon rate # (Double Jeopardy Bonds) Allows the issuer to make coupon payments by increasing principal amount of the outstanding bonds Coupon payments do not begin until a period of time after issuance Coupon payments and/or a principal repayment is based on a commodity index, equity index or some other index Inflation-linked bonds - Mest common type Principal protected bonds - Indexed bonds that do not pay less than their original par value at maturity Contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities Ee uae a eh ues te Oe eC esa > Conversion value - No. of shares received after conversion oie Rue Ue on a ee Cu eu oe ocr eee RR eu oe Ree ie Ret iity > Callable bonds - Issuer can buy back the bond from bondholder (value to the issuer) Pe SE So eS ea Ue ea ee Reta Cee eC Li) > Convertible bonds - Option to exchange the bond for shares (value to the bondholder) ‘Owners of these bonds have downside protection. Often referred to as hybrid security Ser a ee ket ne ue ead the bond's par value, bondholders might not convert the bonds to common stock because the iterest yield > dividend yield on common shares received through conversion. For thi reason, many convertible bonds have call provision Se Ce ens ng oe price over a given period of time SR no ae ore aCe a a suey rose Gee eet ‘ll queries/doubts about this reading can be posted on FinTree Forum for the reading Watch video with important 40https://www-fintreeindia.com! (© 2022 FinTree Education Pvt. Ltd. Fixed-income Markets: Issuance, Trading And Funding LOS a Classifications of global fixed-income markets T T T T T T T 1 Type of Credit Original. = Coupon Tax issuer quality maturity — structure «Currency Geography Indexing statue + + + + BBB and above - Fixed rate or Developed Municipal bonds - Investment grade floating rate markets - Less Tax exempt, lower bonds riskier yield BB and below - Emerging markets Junk bonds = More riskier Government, Money USD, Euro etc. Index-linked corporation market, bonds ete. capital market securities LOSb Use of reference rates in floating-rate debt Pee hein et rar ee ci) ers ee Itis a rate at which one bank lends another bank oes Currency is USD Issued out of US crore) Cur) Eee uate) PELE Ts Ce eeu ea eget co) ee see ia nec y LOSc —_ Mechanisms available for issuing bonds in primary markets Public offering - Bonds are sold to the public Private placement - Bonds are sold only to qualified investors Grey market - Bonds trading prior to offering date Underwritten offering - Entire bond issue is purchased by the investment bank (underwriter) Best efforts offering - Investment bank does not commit to purchase the whole issue Losd Secondary markets Markets where previously issued bonds trade Most bonds are traded in dealer markets (OTC markets) Liquid issues - Difference between bid-ask price is narrower Less liquid issues - Difference between bid-ask price is wider 4hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Settlement cycle: Government bonds - T+1 Corporate bonds - T+2 or T+3 LOSe Securities issued by sovereign governments Sovereign (national) governments issue bonds that are backed by the taxing power Sovereign governments may issue the bonds denominated in their own currency or fo! n currency On the run issue - Most recently issued securities Credi rating is often higher for local currency bonds : Securities issued by oo SDE perenne] Certs Geremrertat’ agencies Pore Gatecs Term maturity Sinking fund Serial bond issue mructire Redeem a part of the bond periodically Redeem a part of the bond periodically All bonds will mature Investors know in on the same date advance which bonds Investors don’t know in advance which bonds will be onds will will be redeemed LOSg ‘Types of debt issued by corporations feast Paes It is a short term unsecured debt issued by creditworthy companies Term maturity structure - All bonds mature on the same date Bilateral loan - Loan given by only one bank It is used to fund working Syndicated loan - Loan capital given by a group of banks Serial maturity structure - Bonds mature on dates Itis often reissued and rolled over when it matures Rollover risk - The risk that company will not be able to reissue or rollover the CP when it mature 42hups:/hvww.fintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. LOSh Short-term funding alternatives available to banks Customer deposits Certificates of deposit (CDs) Another short-term funding source. CDs mature on specific dates. Negotiable CDs can be sold Banks may buy or sell excess reserves deposited with their central bank Funds loaned by one bank to another Central bank funds market Interbank funds 3 ie Repurchase agreements One party sells a security to a counterparty with a commitment to buy it back at a later date at a specified (higher) price Repo rate - Annualized percentage difference between selling and buying price Repo margin (haircut) - Difference between the market value and the amount loaned Reverse repo - Bond dealer lends funds instead of borrowing js Repo margin will be lower if, Repo rate will be lower if, Collateral is delivered Higher quality of collateral Maturity is shorter General interest rates are lower Borrower has high credit quality Higher quality of collateral Maturity is shorter Security is in short supply and high demand Eg. Sells a security @ 93 (Market Value = 97) Bond > Lender dealer Bond _,_ Promise to buy back @ 96 after 3 months fone Lender = 90/ Repo rate = —gy- = 3.22% Repo margin = 97-93 = 4 ‘I queres/ doubts about this reading can be posted on Watch video with important FinTree Forum for the reading testable concepts here ‘video Unk, 43Pvt. Ltd. bips:/iwww.fintreeindia.com/ (© 2022 FinTree Educ: Introduction To Fixed-Income Valuation Sa Calculating bond price using YTM 5 MV of bond is PV of future CFs discounted at current YTM (Yield-to-maturity) Eg. Calculate the bond price when Maturity = 4 Yrs Coupon rate = 10% YTM = 12% Face value = 1000 N=4 PMT = 100 I/Y=12 FV= 1000 CPT PV = -939.25 LOSb _ Relationship b/w bond price, coupon rate, maturity and YTM Peeks Pe er a eRe | pee et Le eR aes tai) Pee Te ee a Eid Ree eo ee Cu aor) LOSe¢ Calculating bond price using spot rates Spot rates - Market discount rates for a single payment to be received in future They are also called zero rates Eg. Spot rates - 1-Yr- 4% 2-Yr-5% 3-Yr-6% 4-¥r-7% Face value - 1000 Calculate price of the bond = — _ + — 60 __ 5, __60 _ , __1060 __ Price = Gyo0ay + G@+o005y * Groep * G+0.07)" Price = 57.69 + 5442 + 5037 + 808.66 = 97444 LOS d pte ete @irty price) nter g- YTM = 15% Face value = 1000 Coupon rate = 20% 0 5 57 6 10 Price of the bond at year5 - FV= 1000 PMT=200 N=5 I/Y=15 PV=1167 Full price of the bond (5.7) - 1167 x (1 + 0.15)°” = 1287 Flat price of the bond (5.7) - 1287 - (200 x 0.7) = 1147 44ips fiatrecindia com! © 2022 FinTree Education Pt. Lid, LOS e Matrix pricing Method of estimating YTM of the bonds that are not traded Rating must be same but coupon rate does not have to be same Eg. Determine YTM of a non traded BB rated, 5% annual-pay ond that has 4 years remaining until maturity YTMs of similar bonds are: BB rated, 3 year annual-pay, 6% coupon bond - 5.5%. BB rated, 6 year annual-pay, 7% coupon bond - 6.5% 3-year bond - 5.5% Difference in 3 years - 1% 6-year bond - 6.5% Difference in 1 year - 0.33% YTM of non traded bond = 5.5 + 0.33 = 5.83% LOSf Yield measures For annual coupon bond Effective earning yield = Yield to maturity For semi-annual coupon bond Effective earning yield > Yield to maturity Eg. Annual coupon bond Semi-annual coupon bond Face value = 1000 Coupon rate Face value = 1000 Coupon rate = 17% Maturity = 8 yrs. Market value Maturity = 10 yrs. Market value = 870 FV = 1000 PMT = 150 N=8 PV = -800 FV = 1000 PMT = 85 N = 20 PV = -870 CPT I/Y = 19.73 CPT 1/Y = 10.03 x 2 = 20.06 EAY = YTM EAY = (1 + 10.03)’ - 1 = 21.06% EAY > YT Street convention - Yield calculated the stated coupon payment dates True yield - Yield calculated after considering weekends and holidays Street convention yield > True yield _ Annual Coupon jetg - Annual coupon + Disc. amort, ~ Prem. amort. Current yield - Angus) Coupe Simple yield pes ame Semi-annual bond Semi-annual bond Face value = 1000 Coupon rate = 10% Face value = 1000 Coupon rate Maturity = 10 yrs. Market value = 850 Maturity = 10 yrs. Market valu Annual discount amortized = 100/5 = 20 ied =< 202 100 +20 Current yield = $25 Simple yield ‘300 Current yield = 11.76% Simple yield = 13.33% 45‘https:iwww:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. we Yield to call (YTC) Yield to worst (YTW) Eg. Face value = 1000 Coupon rate = 10% Market value = 1020 | Lowest of YTM and YTCs is called Callable in four years at 103 yw - Ave = = =- = OAS - Calculated by adding value of YIC- FV = 1030 PMT = 100 N=4 PY=-1020 I/Y = 10.01% | OAS Calelates Oy ae vero OAS callable yield < YTM of a callable bond flat yield Floating-rate note yields + FRN yield = LIBOR + Quoted margin + Coupon rate for the next period is set using the current reference rate (L1BOR) for the reset period + Values of FRNs are more stable than those of fixed-rate debt of maturity because the coupon interest rates are reset periodically + Issuer with more credit risk - Quoted margin is higher + Issuer with less credit risk - Quoted margin is lower + Required margin (discount margin) - Margin that brings FRN to its par value quality # - Quoted margin > Required mai When this happens we say that FRN is trading at premium it quality ¥ - Quoted margin < Required mai When this happens we say that FRN is trading at discount Money market instrument yields + Yield can be quoted on discount basis or add-on basis + These may be 360-day or 365-day + UST-bills - Quoted as discount bond and is based on 360-day convention + Libor and bank CDs - Quoted as add-on yield + 422255 + Appropriate yield measure for money market instruments - Bond equivalent yield LOS g Yields Maturities ‘Yield curve Displays yields for different maturities 46htips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSh Calculating forward rates using spot rates Eg. Spot,=15% Spot,= 20% Calculate 2-yr forward rate, 5 years from now Formula Logie Magic (Approx.) THT 100 a9q% 358-31 20x7 = 140 fee 1 r————4 (I+ 15%) ° 7 ° 7 100 59, 201.13 358.31 15x5=75 65 -—+—H4 o 5 | 7 ° 5 | 7 33.47% 33.47% 65/2 = 32.5% Calculating spot rates using forward rates Eg. 1-year spot rat 2% 1-year forward rate 1 year from now = 3% 1-year forward rate 2 years from now = 4% Calculate 3-year spot rate Spot rate, = (1.02 x 1.03 x 1.04)" = 2.997% LOSi Yield spread It is the difference between yields of two bonds Benchmark spread Id spread relative to a benchmark bond read - Yield spread reli je to a government bond Interpolated spread (I-spread) - Yield spread relative to a swap rate Z-spread.eg. Risky bond, Face value = 1000 Coupon rate = 10% Maturity = 4 yrs Market value = 860 Spot rates (treasury) - Year 1 - 10%, Year 2- 11%, Year 3 - 12%, Year 4- 15% 100 100 100 1100 860= GF i0% + xepready + (111% + zepready * (1 ¥12% + xapready * (LF 15% + z-apread) Z-spread is determined by trial and error method It is the spread added along the treasury spot curve to make PV of CFs equal to market price of the bond Option adjusted spread (OAS) = Z-spread - Option value Witch video with important testable concepts here ‘Video Unk 47hps:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Introduction To Asset-backed Securities LOSa Benefits of securitization Cee ae g a e Sue cee Pon on Cer Scud Drage racd Rerun eR eS: aru ee} Other benefits: Provides higher risk-adjusted returns for investors eee ok ge a oe After securitization securities are actively traded Cee ae oe ieee ony une eieeurc) Cee ee kuru rca) Dee he EU ee aero nen RCL uy LOSb Securitization process Mortgages, loans are sold a = Receives cash Special purpose ) entity (SPE) | Bank | L Servicer Mortgages and loans —_—" Known as ‘trust’ and is set (assets) are removed from up specifically for buying the B/S these loans and selling ABS. to investors May use cash proceeds to make more loans Services the loans Principal and interest payment received on loans is used to pay servicing fees to the servicer and then to ABS owners Trust may issue ABS in several classes (tranches) Waterfall structure - Each tranche of ABS is paid sequentially SPE is a separate legal entity and buyers of ABS do not have claim on other assets of the bank LOS c¢ Typical structures of securitizations > In‘tranches’ structure - Some tranches bear more risk while other bear less > Credit tranching (senior/subordinate structure) - Losses are first absorbed by the tranche with lowest priority > Time tranching - First tranche receives all principal repayments from underlying assets up to the principal value of the tranche 48https:vww:fintrecindia.com/ © 2022 Fin'Tree Education Pvt Lid, LOSd Residential mortgage loans Collateral of the loan is residential real estate Loan amount Loan-to-value ratio (LTV) [aie of collateral real estate x 100 If # LTY, then borrower's equity * For lenders, + Loans with low LTVs is less riskier (because borrower loses more in case of default) + Ifthe property value is high compared to the loan amount, lender is more likely to recover the amount loaned if borrower defaults Prime loans - Mortgages with high LTV ratios, made to borrowers of high credit quality ‘Subprime loans - Mortgages to borrowers of lower credit quality Characteristics of residential mortgage loans: Maturity - Typically 15-30 yrs Interest rate - Fixed rate, adjustable rate or convertible Amortization - Fully amortizing, partially amortizing or interest-only Prepayment provisions - Some loans have prepayment penalty Foreclosure - Non-recourse and recourse loans ++ eee LOSe&f Residential mortgage backed securities (RMBS) + Agency RMBS - Issued by GNMA, FNMA and Freddie Mac. Agency RMBS are mortgage pass-through securities. Generally high quality. + Non-agency RMBS - Issued by private companies. Non-agency RMBS typically include credit enhancement + Collateralized mortgage obligations (CMOs) - Collateralized by pools of RMBS. ‘They are structured with tranches. ae + 45S First tranche to be paid principal has most contraction risk. + Last tranche to be paid principal has most extension risk + Planned amortization class (PAC) tranches - A PAC tranche is structured to make predictable payments, regardless of actual prepayments. PAC tranches have both reduced contraction and extension risk + Prepayment risk - Uncertainty about timing of the principal CFs from the ABS + Contraction risk - Risk that loan principal will be repaid more rapidly than expected (when interest rates decrease) ill be repaid more slowly than 49-https:/iwww:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOS g Commercial mortgage backed securities (CMBS) + CMBS are backed by income-producing real estate properties such Pere cs eae Reus eee ee Oey Pe eee ocd See SEC el Rotates Ee ete Cur + There is a two level call protection (Ioan level and structural level) Sede ad Cae acd Cire eeiccr LOSh Non-mortgage ABS ABS may backed by financial assets other than mortgages. Eg. Auto loan ABS and credit card ABS PCPA) Reet) Backed by credit card ivables Backed by automobile loans nan ‘Typically fully amortising Non: are (revolving Have a lockout period during which only interest spa Shorter maturities than RMBS 50hips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSi > > Collateralized debt obligations (CDOs) Collateral is a pool of debt obligations that is managed by a collateral manager Collateralized bond obligations (CBOs) - When collateral securities are corporate and emerging market debt Structured finance CDOs - Collateral is ABS, RMBS, other CDOs and CMBS Collaterali 1d loan obligations (CLOs) - Backed by leveraged bank loans Synthetic CDOs - Collateral is portfolio of credit default swaps (CDS) on structured securities RFR + Selling CDS (CDOs have 3 tranches - Senior bonds, mezzanine bonds, and subordinated bonds ‘Al queries/doubts about this reading can be posted on Watch video with important FinTree Forum for the reading ‘video Unk 51https://www-fintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. Understanding Fixed-Income Risk And Return LOSa Sources of return from fixed-rate bond © Coupon and principal payments © Reinvestment of coupons © Capital gain/loss if bond is sold before maturity ‘An investor always earns at YTM, if he holds the bond till maturity and reinvests at YTM Interest rate risk (market price risk) - Uncertainty about bond’s price CO Cae et ca ou cer cd Shorter investment horizon - Interest rate risk > reinvestment risk Ue eau ee et eee td po Rae ead ace ae aaa aa) For ZCBs, Macaulay duration = Bond maturity For Fixed coupon bond, Macaulay duration < Bond maturity Macaulay duration > Modified duration For semi Modified duration (annual compounding) - ee i-annual compounding - (1 + YTM/2) V_ = Higher bond price V_ = Lower bond price V, = Base price Eg #1 Macaulay duration Maturity | Cash flow | Dise. CF | Weights | Weighted avg. Face value = 1000 Coupon rate = 15% a 150 | 136.36 |16.83%| 0.17 Maturity = 4 yrs 2 150 | 113.42 [14.00%| 0.28 10% 1096 3 150 | 86.8 |10.74%| 0.33 20% 4 1150 | 471.04 | 58% 2.32 Macaulay 25% il Total 807.63 3.1 <———_ duration 52httpsi/wwwfintreeindia.com/ © 2022 FinTree Education Pvt. Ltd. Eg #2 Modified duration Face value = 1000 Ce ee CTS ORGS parC 9% 11% 6.4% = 58% 1064 <—_ 1000 ——————_-» 941 Modified duration = £2259. 6.15 Interpretation - If yield changes by 1%, bond price will change by 6.15% LOS c Why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options ? Embedded options have uncertain future CFs, because of which PV calculations for bond value based on YTM cannot be used LOSd Key rate duration (partial duration) Parallel shift in yield curve Nonparallel shit Duration Key rate duration Key rate duration - Measure of sensitivity of price of a bond to a change in spot rate for a specific maturity. It captures shaping risk. LOSe Effect of maturity, coupon and yield on duration oa, 4 Effect Bond price Bond price Maturity Duration # ‘Coupon # Duration + YIM & Duration + vita viet Callable bond Putable bond o (Lower duration (Lower duration Callable bond - Lesser duration when yields ‘at lower yield) cthigher yield) Putable bond - Lesser duration when yields Optionality of bond will never increase the duration 53htips:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. LOSf Duration of portfolio TH Calculating weighted Calculating weighted ‘average number of average of durations of periods until the individual bonds in the portfolio’s cash flows will be received | portfolio) | Not useful for @ portfolio that contains bonds with embedded options portfolio | ‘This approach is used in practice | Useful for a portfolio that contains bonds with ‘embedded options Weights are based on full price of each bond Limitation - For portfolio duration to ‘make sense’ the YTM of every bond the portfolio must change by the same amount (parallel shift) Money duration x % A in YTM = Change in bond price (absolute amount) Eg. Market value = $1050 Modified duration = 6 A in yield = 50 bps Money duration = Modified duration x Full price = 6x 1050 = $6300 Change in bond price = Money duration x % Ain YTM = 6300 x 0.5% = $31.25 PVBP = 0.5% ~ $31.25 0.01% ~ $0.625 54https://www-fintreeindia.com! LOSh (© 2022 FinTree Education Pvt. Ltd. Convexity EeKareenr Cotte eet Cem hs pee Ld 9% 11% (V.+V,) = 2M, Vx (AY) +6.4% = 5.9% 1064 <0 941 ‘Convexity refers to the curvature of a bond's price-yield relationship Due to convexity(+ve), bond price increases more for a given change in yield as compared to decrease(%) for same change in yield Increase in yield causes price to decrease at decreasing rate and Creed foe aies LOSi Calculating % A in the full price of a bond % A full price of bond = —Duration(AY) + 1/2 x Convexity(AY)’ LOSj Term structure of yield volatility and duration Term structure of yield volatility - Relationship between maturity and yield volat Short-term yields may be more volatile than long-term yields LOSk _ Relationship between bond’s HPR, duration and investment horizon FV = 1000 Coupon = 12.55% YTM = 5% Price risk Reinvestment dominates Fisk dominates er a -1583 1000 o 3 7 10 | Macaulay duration | @ vinzon ,,Realzed Realized yield is Realized yield yieldislower close to 5% is higher = yo, Realized yield Realized yield is _—_—Realized @ m= 2% Ss higher close to 5% yield is lower 55bups:/iwww.fintreeindia.com! © 2022 FinTree Education Pvt. Ltd. Duration gap = Duration gap = +e Macaulay duration | Duration gap = Zero LOS] How changes in credit spread and liquidity affect YTM Bond’s spread to benchmark curve has two components Credit risk premium and Liquidity premium ren change in any of these components will have direct impact on YTM ‘il queries/ doubts about this reading can be posted on Watch video with important intree Forum forthe reeding, testable concepts here Forum Link Video Link 56‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Fundamentals Of Credit Analysis LOSa&b Credit risk _ Possibility of failure of a borrower to make timely and full payments of interest or principal. It has two components. Default risk - Probability that borrower (issuer) fails to pay interest or repay principal Loss severity (loss given default) - Value a bond investor will lose if the issuer defaults. 1 — Recovery rate Expected loss _ Default risk x loss severity Recovery rate _% of bond value investor receives, if issuer defaults Downgrade risk _ Possibility that spreads will increase because the issuer has (Credit ation risk) _ become less creditworthy Liquidity risk _ Risk of receiving less than market value Spread risk Possibility that bond's spread will widen due to downgrade risk or liquidity risk or both LOS ¢ Seniority rankings Seniority ranking - Bond's priority of claims to the issuer's assets First lien Cee cg pines kad ogi oad Cee eed Crue nad BT uee Td All debt within the same category is said to rank pari passu. They have same Priority of claims Lower seniority + Higher credit risk + Higher YTM. Since bankruptcies are costly and take a long time to settle, strict pri claims may not be followed Losd Issuer credit ratings ee eee Called as Corporate Family Ratings (CFR) Called as Corporate Credit Ratings (CCR) Based on the overall ings (CcR) creditworthiness of the company [MJ Based on credit risk of specific debt i Issuers are rated on their senior unsecured debt 57htps:/iwww.fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Notching _Itis the practice by rating agencies of assigning different ratings to bonds of the same issuer Structural Bonds of parent company are subordinate to bonds of sub: subordination company LOSe Risks in relying on ratings from credit rating agencies Credit ratings | { Rating agencies | { Eventriskis | {Credit ratings lag are dynamic are not perfect | {difficult to assess| | market pricing Credit ratings Rating agencies Specific risks of a Market change overtime cannot always judge company or industry _credit spreads credit risk accurately are difficult to change much faster predict and than credit ratings incorporate into credit ratings LOSf 4 Cs of traditional credit analysis o ity - Borrower's ability repay its debt obli s of it~ OS g Financial ratios used in credit analysis Boar) rer ead feed LOSh Evaluating credit quality Indicators of lower credit risk (higher credit rating) - + Leverage, # Interest coverage, and # free cash flow Analyst should con: ler underfunded pensions and off-balance-sheet financing while calculating leverage ratios 58https://www-fintreeindia.com! (© 2022 FinTree Education Pvt. Ltd. LOSi Factors that influence level and volat ity of yield spreads Credit cycle - Credit spreads narrow as credit cycle improves. Credit spreads widen Peer or erie Se ee eC ee ea cau ca Peau Financial market performance - Spreads narrow in strong-performing markets, Pee en Une ea acd Ce eee Ca sce ee a ed capital, Spreads widen when capital becomes scarce Market demand and supply - Spreads narrow when demand > supply, spreads widen when demand < supply Yield spreads on lower-quality issues tend to be more volatile than spreads on higher-quality issues Losj Special considerations when evaluating different debts { High yield debt Sovereign debt ] (Non-sovereign debt] t t + More likely to default Credit risk i than investment grade country’s al Analysis is similar to bonds willingness to pay analysis of sovereign debt is should focus Credit risk is lower for uidity, projected bonds issued in Focus is on local financial performance, |country’s own currency| ‘economy and its effect debt structure and than for bonds issued on tax revenues debt covenants in foreign currency ‘All queries/doubts about this reading can be ported on FinTree Forum for the Feasing 59Derivatives Notice : Unless otherwise stated, copyright and all intellectual property rights in all the course material(s) provided, is the property of FinTree Education Private Limited. Any copying, Bie Megat aroun CC Ur a em eC purpose provided shall tantamount to infringement and shall strongly defended and pursued, UC Cece cc an The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute code of Ethics. Your assistance in pursuing potential violators of this law is greatly Seer RAC he ek TR een Re) We have concealed a user specific code within this material to identify the original user. In case of violation of copyright laws, duplication or mass circulation of this material, the original user to whom this material was issued will be identified and pursued under appropriate laws. Further, the user indetification will also be reported to CFA Institute.eas & a FinTree\. Ete Tula Trt) Atte) Br TerITS Check out some Awesome Study ty Material of FinTree ES ery Tr is LNT) Ty‘https:www:fintreeindia.com/ (© 2022 FinTree Education Pvt. Ltd. Derivative Markets and Instruments LOSa Define a derivative A derivative is a security that derives its value from the value of underlying asset Exchange-traded derivatives - These are standardized and backed by a clearinghouse Eg. Options and Futures Over-the-counter derivatives - These are traded by dealers in a market with no central location. OTC markets are unregulated and each contract is with a counterparty ‘This may expose the owner to default risk Eg. Forwards, swaps and options rose t Legally binding promise to perform some action in the future Eg. forwards, futures and swaps 1 Claim that depends on a particular event Eg. Options and Credit derivatives OE eure ncial) from seller (short) at esa Dente et Gare erent ei tosd prc) There is default risk associated De Or arc) Tc) Se Rat icy standardized and exchange-traded FO ea Gr tT DCE CouUr at Pete gees ac market) BCR amar ees eee ea Both Forwards and Futures are deliverable/cash-settled contracts Deliverable and cash settled contracts are economically equivalent Both of them have contract value of zero at i Hiation Settlement price - It is average of the prices of the trades during the last period of trading (closing period) 62