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![affects a company’s future cash flows -> equity
The requirements are more specific in some situations. For e.g,
regulations governing disclosures of conflicts and potential conflicts
of interest vary across countries, investment recommendations are
affected by policies of the firm employing an analyst
29. Equity Valuation:
Applications and Processes
- Part 1
Introduction
Valuation
The estimation of an asset’s value based on variables perceived to be related to future investment
returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds
Basic questions
What is value?
Who uses equity valuations?
What is the importance of industry knowledge?
How can the analyst effectively
communicate his analysis?
Value Definition and
Valuation Applications
Definition
Intrinsic Value
The value of the asset given a hypothetically complete
understanding of the asset’s investment characteristics
Reflects investor's view of the “true” or “real” value of an asset
Grossman-Stiglitz paradox
Market price and intrinsic
value are identical
Rational efficient
markets formulation
Investors will not rationally incur the expenses of
gathering information unless they expect to be
rewarded by higher gross returns compared with
the free alternative of accepting the market price
Difficult to determine especially
Common stock
Trading costs exist
Further room exists for price to diverge from value
Analysts often view market prices both
with respect and with skepticism
Seek to identify mispricing
A difference between the estimated intrinsic
value and the market price of an asset
Rely on price eventually converging to intrinsic value
Recognize distinctions among the levels
of market efficiency or tiers of markets
Valuation is an inherent part to attempt positive excess
risk adjusted returns (abnormal return or alpha)
Uncertainty is
constantly present
Revaluate by looking for the presence of a
particular market or corporate event ( catalyst)
VE - P = (V - P) + (VE - V)
VE = estimated value
P = market price
V = intrinsic value
(V-P): the true mispricing, the difference between the true but
unobservable intrinsic value V and the observed market price P
Contribute to the abnormal return
(VE-V): the difference between the valuation
estimate and the true but unobservable intrinsic value
The error in the estimate of the intrinsic value
A useful estimate
of intrinsic value
Combine accurate forecasts and
appropriate valuation model
Expectational inputs used in valuation models
Active security selection
Manager’s expectations must differ from
consensus expectations and be correct
Going-Concern Value and Liquidation Value
Going-concern assumption
The assumption that the company will continue
its business activities into the foreseeable future
valuemaximizing using assets
accessing its optimal sources of financing
not appropriate for a company in financial distress
The value added by assets working together and by human capital applied to managing
those assets makes estimated goingconcern value greater than liquidation value
Liquidation value
Different time frame for liquidating causes different assets value of a company
Orderly liquidation value
Fair Market Value and Investment Value
Fair market value
is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and the latter is not under any compulsion to sell
includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment
often used in valuation related to assessing taxes
Investment value
The concept of value to a specific buyer taking account of potential
synergies and based on the investor’s requirements and expectations
Valuation Applications
Selecting stocks Primary use
Inferring (extracting ) market expectations
evaluate the reasonableness of the expectations
as a benchmark or comparison value of the same characteristic for another company
Evaluating corporate events
A merger the general term for the combination of two companies
An acquisition
a combination of two companies, with one of the companies
identified as the acquirer, the other the acquired
the acquiring company’s own common stock
is often used as currency for the purchase
A divestiture a company sells some major component of its business
A spin-off
the company separates one of its component businesses and transfers
the ownership of the separated business to its shareholders
A leveraged buyout
an acquisition involving significant leverage [i.e., debt], which is
often collateralized by the assets of the company being acquired.)
Rendering fairness opinions
The parties to a merger may be required to seek a fairness opinion on
the terms of the merger from a third party, such as an investment bank
Evaluating business strategies and models
Companies concerned with maximizing shareholder value
evaluate the effect of alternative strategies on share value
Communicating with analysts and shareholders
Appraising private businesses for transactional purposes
E.g acquisitions or buy-sell agreements for the transfer of equity
interests among owners when one of them dies or retires, IPO,...
Sharebased payment (compensation)
Communicating Valuation Results
Contents of a Research Report
Kind of infor. intended readers seek to gain
Sell-side analyst’s report:
investment recommendation
Persuasive supporting
arguments
The intrinsic value
of the security
The key assumptions and
expectations underlying that
estimated intrinsic value
An update on the company’s
financial and operating results
A description of relevant aspects of the
current macroeconomic and industry context
An analysis and forecast for
the industry and company
Detailed historical descriptive statistics
about the industry and company
When a research report states a
target price for a stock, it should
clarify
the basis for computing the target
information on the uncertainty of reaching the target
a time frame for reaching the target
May be accompanied by an explanation of the underlying rationale
Usual contents
Specific forecasts
A description of the valuation model
Key valuation inputs
A discussion of qualitative factors and other considerations that affect valuation
Objectively address the uncertainty associated with investing in the security,
and/or the valuation inputs involving the greatest amount of uncertainty
Contains timely information
is written in clear, incisive language
is objective and well researched, with key assumptions clearly identified
distinguishes clearly between facts and opinions
contains analysis, forecasts, valuation, and a recommendation that are internally consistent
presents sufficient information to allow a reader to critique the valuation
states the key risk factors involved in an investment in the company
discloses any potential conflicts of interests faced by the analyst
Format of a Research Report
Research Reporting Responsibilities
All analysts have an obligation to provide substantive and
meaningful content in a clear and comprehensive report format
Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to
the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports
The analyst must hold himself accountable to both standards of competence and standards of conduct
An effective research report
29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
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![49. Option Markets
and Contracts - Part 2
A CHANGE IN THE VALUE OF
EACH INPUT AFFECTS THE
OPTION PRICE (UNDER THE
BLACK-SCHOLES-MERTION
MODEL)
A Greek is a sensitivity factor that captures the relationship between each input (asset
price, asset price volatility, time to expiration, and the risk-free rate) the option price
Delta describes the relationship between asset price and option price
Vega measures the sensitivity of the option price to changes
in the volatility of returns on the underlying asset
Rho measures the sensitivity of the option price to changes in the risk-free rate
Theta measures the sensitivity of the option price to the passage of time
theta is less than zero: as time passes and the option
approaches the maturity date, its value decreases
THE DELTA OF AN OPTION AND
ITS USE IN DYNAMIC HEDGING
Delta is the change in the price of an option for a one-unit change in the price of the underlying security C = change in the price of the call over a short time interval
S = change in the price of the underlying stock over a short time interval
Use BSM model to estimate the change in the value of the call
given the change in the value of the stock and the option's delta
C N(d1) x S
P (change in put price) [N(d1) - 1] x S
Interpreting Delta
A call option delta is between
0 and 1. If the call option is
Out-of-the-money (stock price is less than exercise price), the call delta moves
closer to 0 as time passes, assuming the underlying stock price doesn't change
In-the-money (stock price is greater than exercise price), the call delta moves
closer to 1 as time passes, assuming the underlying stock price doesn't change
A put option delta is between
-1 and 0. If the put option is
Out-of-the-money (stock price is greater than exercise price), the put delta moves
closer to O as time passes, assuming the underlying stock price doesn't change
In-the-money (stock price is less than exercise price), the put delta moves
closer to -1 as time passes, assuming the underlying stock price doesn't change
Dynamic Hedging
The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short
position in a call option so that the value of the portfolio does not change when the value of the stock changes
Number of call options needed to delta hedge = number of shares hedged/delta of call option
Number of put options needed to delta hedge = number of shares/delta of the put option
The delta-neutral position only holds for very small changes in the value of the underlying stock
=> must be continually rebalanced to maintain the hedge (a dynamic hedge)
costly in terms of transaction costs
Gama effect
Gamma measures the rate of change in delta as the underlying stock price changes
can be viewed as a measure of how poorly a dynamic hedge will perform
when it is not rebalanced in response to a change in the asset price
Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas
Long positions in calls and puts have positive gammas
Gamma is largest when a call or put option is at-the-money and close to expiration
EFFECT OF THE UNDERLYING
ASSET'S CASH FLOWS ON
THE PRICE OF AN OPTION
All else equal, the existence of cash flows on the underlying asset will
Decrease the value of a call option
Increase the value of a put option
Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF)
THE HISTORICAL AND
IMPLIED VOLATILITIES OF
AN UNDERLYING ASSET
The steps in computing historical volatility for use as an
input in the BSM continuous-time options pricing model are
Step 1: Convert a time series of N prices to returns
Step 2: Convert the returns to
continuously compounded returns
Step 3: Calculate the variance and standard
deviation of the continuously compounded returns
Implied volatility is the value for standard deviation of continuously compounded
rates of return that is "implied" by the market price of the option
when used in the Black-Scholes formula, it produces the current market price of the option
PUT-CALL PARITY FOR
FORWARD/FUTURES OPTIONSPut-call parity for options on forwards and futures is as follows
American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest
Americans and European options on forward contracts are equivalent because there is no mark to market
AMERICAN/EUROPEAN OPTIONS
ON FUTURES AND FORWARDS
AND APPROPRIATE PRICING
MODEL FOR EUROPEAN OPTIONS
There is a benefit to early exercise of options on futures when they are deep in the money
Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn
interest, while the futures position will gain or lose from movements in the futures price => these price
movements between early exercise and option expiration will mirror those of the deep in the money option
With no reason for early exercise, the value of American
and European options on forwards are the same
There is no mark to market on forwards, early exercise does not accelerate the payment of any gains
The Black model can be used to price European options on forwards and futures
= standard deviation of returns on the futures contract
FT = futures price
American options on futures are more valuable
than comparable European options because
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The document outlines the Code of Ethics and Standards of Professional Conduct for CFA Institute members and candidates. It discusses the basic structure for enforcing the Code and Standards, including the CFA Institute Board of Governors and Disciplinary Review Committee. Six key components of the Code of Ethics are described relating to acting with integrity, competence, respecting clients' interests, and encouraging ethical practices. The seven Standards of Professional Conduct cover areas like professionalism, duties to clients and employers, conflicts of interest, and responsibilities as a CFA member or candidate. Specific guidance is provided on issues like maintaining independence and objectivity, prohibitions on misrepresentation, and handling non-public information.
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- 2. 1. Code OfEthics And Standards Of Professional Conduct a. All CFA Institute members and candidates are required to comply with the Code and Standards Structure of the CFA Institute Professional Conduct Program Basic structure for enforcing the Code and Standards The CFA Institute Bylaws Rules of Procedure Based on two primary principles Fair process to member and candidate Confidentiality of proceedings Professional Conduct program (PCP) The CFA Institute Board of Governors Maintains oversight and responsibility Through the Disciplinary Review Committee (DRC) Is responsible for the enforcement of the Code and Standards The CFA Designated Officer Directs professional conduct staff Conducts professional conduct inquiries An inquiry can be prompted by several circumstances Selfdisclosure Written complaints Evidence of misconduct Report by a CFA exam proctor Analysis of exam materials and monitoring of social media by CFA Insitute Process for the enforcement of the Code and Standards When an inquiry is initiated The Professional Conduct staff conducts an investigation that may include Requesting a written explanation from the member or candidate Interviewing The member or candidate Complaining parties Third parties Collecting documents and records in support of its investigation Upon reviewing the material obtained during the investigation, the Designated Officer may Conclude the inquiry with no disciplinary sanction Issue a cautionary letter Continue proceedings to discipline the member or candidate If finding that a violation of the Code and Standards occurred, the Designated Officer proposes a disciplinary sanction Accepted by member Rejected by member The matter is referred to a hearing by a panel of CFA Institute members If sanction is imposed condemnation by the member's peers suspension of candidate's continued participant in the CFA program b,c. Six components of the Code of Ethics Act with integrity, competence, diligence, respect and in an ethical manner Integrity of investment profession & interest of clients above personal interest Care & judgment Practice ethics & encourage others to practice Integrity & viability of the global capital markets Professional competence Seven Standards of Professional Conduct Professionalism Integrity of Capital markets Duties of Clients Duties to Employers Investment analysis, Recommendations & Actions Conflict of interest Responsibilities as a CFA Institute member or CFA Candidate WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com 1. Code Of Ethics And Standards Of Professional Conduct - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS
- 3. 2.1 Standard I PROFESSIONALISM A.Knowledge of the law Guidance Understand and comply with applicable laws and regulations Code and Standards vs. Local law Follow stricter law and regulation Participation or association with violations by others Responsible for violations in which they knowingly participate or assist Dissociate from illegal, unethical activities Leave employers (in extreme case) Intermediate steps Attempt to stop the behavior by bringing it to the attention of employer through a supervisor or compliance department May consider directly confronting the involved individuals If not successful,--> step away and dissociate from the activity by Removing their name from written reports Asking for a different assignment Inaction with continued association may be construed as knowing participation Not required reporting violations to government, CFAI, but advisable in some cases or required by laws in others Recommended procedures for compliance (RPC) Members and candidates Stay informed Review procedures Maintain current files When in doubt, seek advice of compliance personnel or legal counsel When dissociating from violations, --> Document any violations and urge firms to stop them Firms Develop and/or adopt a code of ethics Make available to employees info that highlights applicable laws and regulations Establish written procedures for reporting suspected violation of laws, regulations or company policies Application B. Independence and objectivity Guidance Maintain independence and objectivity in professional activities How to cope with external and internal pressures External pressures By benefits Gifts, Invitations to lavish functions, Tickets, Favors, Job referrals, Allocation of shares in oversubscribed IPOs... From public companies To issue favorable reports From Buyside clients May try to pressure sellside analysts Internal pressures From their own firms e.g. to issue favorable research reports/ recommendations for certain companies Investmentbanking relationships to issue favorable research on current or prospective investmentbanking clients Conflicts of interest --> Modest gifts and entertainment are acceptable but special care must be taken must disclose to employers Best practice: reject any offer of gifts, threatening independence and objectivity Recommendations must convey true opinions free of bias from pressures be stated in clear and unambiguous language Portfolio managers must respect and foster honesty of sellside research Issuerpaid research Is fraught with conflicts Analysts Must engage in thorough, independent, and unbiased analysis Must fully disclose potential conflicts, including the nature of compensation Must strictly limit the type of compensation they accept for conducting research Best practice Accept only flat fee for their work prior to writing the report Without regard to conclusions or recommendations RPC Protect integrity of opinions Create a restricted list Restrict special cost arrangements Limit gifts Restrict employee investments Equity IPOs Private placements Review procedures Written policies on independence and objectivity of research C. Misrepresentation Guidance Definition of "Misrepresentation" any untrue statement or omission of a fact or any false or misleading statement Must not knowingly make misrepresentation or give false impression in oral representations, advertising electronic communications written materials Must not misrepresent any aspect of practice, including qualifications or credentials, services performance record Without regard to conclusions or recommendations characteristics of an investment any misrepresentation relating to member's professional activities Must not guarantee clients specific return on investments that are inherently volatile Standard I(C) prohibits plagiarism in preparation of material for distribution to employers, associates, clients, prospects, general publish RPC Written list of available services, description of firm's qualification Designate employees to speak on behalf of firm Prepare summary of qualifications and experience, list of services capable of performing To avoid plagiarism Maintain copies Attribute quotations Attribute summaries D. Misconduct Guidance Address conduct related to professional life Violations Any act involving lying, cheating, stealing, other dishonest conduct that reflects adversely on member's professional activities would be violation Conduct damaging trustworthiness or competence (include behaviour may not be illegal but negatively affect a member to perform responsibility such as abusing alcohol during lunch hours) Abuse of the CFA Institute Professional Conduct Program Involved in personal bankruptcy is not automatically assumed to be in violation but bankruptcy involve fraudulent or deceitful business conduct may be a violation RPC Develop and/or adopt a code of ethics Disseminate to all employee a list of potential violations Check references of potential employees 2.1 Standard I PROFESSIONALISM - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 4. 2.2 Standard II INTEGRITYOF CAPITAL MARKETS A. Material non-public information (MNI) Guidance Definition of "Material nonpublic information" Material information its significant impact to the price of security if it is disclosed Reasonable investors would like to know for making decision The reliability of the information Non-public until disseminated to the market place and effficient time for investors to react Must be particularly aware of info selectively disclosed by corporations Mosaic Theory Analysis of Public info + nonmaterial nonpublic info --> Investment conclusion Analysts are free to act on this collection of info without risking violation Analysts should save and document all their research RPC Make reasonable efforts to achieve public dissemination of material info If public dissemination is not possible, Must communicate the info only to the designated supervisory and compliance personnel within the firm Must not take investment action on the basis of the info Must not knowingly engage in conduct inducing insiders to privately disclose MNI Encourage firms to adopt compliance procedures preventing misuse of MNI develop & follow disclosure policies to ensure proper dissemination use "firewall" Prohibition of all proprietary trading while firm is in possession of MNI may be inappropriate B. Market manipulation Definition Distort prices or artificially inflate trading volume with the intent to mislead market participants can be related to transactions that deceive market participants Transactions that artificially distort prices or volume Securing a controlling, dominant position in a financial instrument to exploit and manipulate price of a related derivative/or underlying asset dissemination of false or misleading info including spreading false rumors to induce trading by others Standard II(B) not meant to prohibit legitimate trading strategies prohibit transactions done for tax purposes The intent of action is critical to determining whether it is a violation of this Standard 2.2 Standard II INTEGRITY OF CAPITAL MARKETS - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 5. http://waytofinancesuccess.com WAY TO FINANCESUCCESS- Website: http://waytofinancesuccess.com To be continued… For MORE CFA® Mind Maps, please go to:http://waytofinancesuccess.com
- 6. 9. Correlation and Regression- An Overview A sample covariance, a sample correlation coefficient and a scatter plot Limitation to correlation analysis Uses of correlation Analysis Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance Distinguish between the dependent and independent variables in a linear regression Describe the assumptions underlying linear regression and interpret regression coefficient Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable Calculate and interpret a confidence interval for the predicted value of the dependent variable Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic Describe limitations of regression analysis 9. Correlation and Regression - An Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 7. 9. Correlation and Regression- Part 1 A sample covariance, a sample correlation coefficient and a scatter plot Scatter Plots A graph that shows the relationship between the observations for two data series in two dimensions Each observation in the scatter plot is represented as a point, and the points are not connected The scatter shows only the actual observation of both data series plotted as pairs Correlation Analysis Correlation analysis expresses the same relationship (between two data series) using a single number The correlation coefficient measures the direction and extent of linear association between two variables A correlation coefficient can have a maximum value of 1 and a minimum value of -1 A correlation coefficient less than 0 indicates a negative linear association A correlation coefficient greater than 0 indicates a positive linear association A scatter plot of two variables with a correlation of 0; they have no linear relation -> the value of A tells us nothing about the value of B Calculate the Correlation Coefficient The sample covariance of X and Y, for a sample of size n The expression for the sample variance of X, is The sample correlation coefficient Limitation to correlation analysis Correlation may be an unreliable measure when Two variables can have a strong nonlinear relation and still have a very low correlation Outliers are present in one or both of the series. Outliers are small numbers of observations at either extreme (small or large) of a sample Spurious correlation correlation between two variables that reflects chance relationship in a particular data set correlation induced by a calculation that mixes each of two variables with a third correlation between two variables arising not from a direct relation between them but from their relation to a third variable Uses of correlation Analysis In investment decision-making (for example: inflation forecast) Correlation of stock market tells us how successfully the assets can be combined to diversify risk Used in a financial statement setting Formulate a test of the hypothesis that the population correlation coefficient equals zero and determine whether the hypothesis is rejected at a given level of significance H0: the correlation in the population is 0 (p = 0) Ha : the correlation in the population is different from 0 (p # 0) The formula for the t-test This test statistic has a t-distribution with n-2 degrees of freedom if the null hypothesis is true Sampling from the same population, a false null hypothesis H0: is more likely to be rejected as we increase sample size. The result whether H0 is rejected also depends on significance level Distinguish between the dependent and independent variables in a linear regression Linear regression with one independent variable (or simple linear regression) models the relationship between two variables as a straight line Linear regression provides a simple model for forecasting the value of one variable, known as the dependent variable, given the value of the second variable, known as the independent variable 9. Correlation and Regression - Part 1.mmap - 4/28/2016 - Mindjet
- 8. Ensure that linearregression produces the correct estimates use the linear regression model to determine the distribution of the estimated parameters and and thus test whether those coefficients have a particular value 9. Correlation and Regression - Part 2 Describe the assumptions underlying linear regression and interpret regression coefficient The regression equation Y: dependent variable X: independent variable b0: the intercept b1: a slope coefficient b0, b1 are the regression coefficients Slope coefficient The estimated slope coefficient is interpreted as the change in the dependent variable for a 1-unit change in the independent variable The intercept term The intercept is an estimate of the dependent variable when the independent variable takes on a value of zero error term (represents the portion of the dependent variable that cannot be explained by the independent variable Six classic normal linear regression model assumptions The relationship between the dependent variable, Y, and the independent variable, X is linear in the parameter b0 and b1. b0 and b1 are raised to the first power only and that neither b0 nor b1 is multiplied or divided by another (for example, b0/b1). The requirement does not exclude X from being raised to a power other than 1 Critical for a valid linear regression. If the relationship between the independent and dependent variables is nonlinear in the parameters, then estimating that relation with a linear regression model will produce invalid results The independent variable, X, is not random The expected value of the error term is 0 The variance of the error term is the same for all observations: The error term is uncorrelated across observations. Consequently, E(ei,j) = 0 for all i not equal to j. The error term is normally distributed Calculate and interpret the standard error of estimate, the coefficient of determination, and a confidence interval for a regression coefficient The formula for the standard error of estimate (SEE) for a linear regression model with one independent variable is The different between the actual and predicted values of the dependent variable is the regression residual The coefficient of determination (R^2) defined as the percentage of the total variation in the dependent variable explained by the independent variable R^2 = r^2 for a regression with one independent variable Regression coefficient confidence interval Confidence interval spans the range A confidence interval is an interval of values that we believe includes the true parameter value, , with a given degree of confidence Formulate a null and alternative hypothesis about a population value of a regression coefficient and determine the appropriate test statistic and whether the null hypothesis is rejected at a given level of significance A hypothesis test using the confidence interval approach if we know the estimated parameter value the hypothesized value b0 or b1 a confidence interval around the estimated parameter In practice, the most common way to test a hypothesis using a regression model is with a t-test of significance. To test the hypothesis, we can compute the statistic This test statistic has a t-distribution with n-2 degrees of freedom. Reject H0 if t> +tcritical or t <-tcritical The appropriate test structure for the null and alternative hypothesis: H0: b1 = 0 versus Ha: b1 # 0 Calculate the predicted value for the dependent variable, given an estimated regression model and a value for the independent variable If we know Calculate and interpret a confidence interval for the predicted value of the dependent variable The prediction interval for a regression equation for a particular predicted value of the dependent variable Y Where sf = standard eror of the forecast tc is two-tailed critical t-value at the desired level of significance with df = n-2 The formula to calculate sf variance of the residuals = the square of the standard error of estimate variance of the independent variable X value of the independent variable for which the forecast was made Describe the use of analysis of variance (ANOVA) in regression analysis, interpret ANOVA results, and calculate and interpret the F-statistic Analysis of variance (ANOVA) is a statistical procedure for dividing the total variability of a variable into components that can be attributed to different sources Use ANOVA to determine the usefulness of the independent variable or variables in explaining variation in the dependent variable The F-test tests whether all the slope coefficients in a linear regression are equal to 0 The null hypothesis H0: b1 =0 The alternative hypothesis Ha: b1 # 1 Formula for the F-statistic in a regression with one independent variable is SSE (The sum of squared errors or residuals) RSS (The regression sum of squares) TSS = SSE + RSS If there are n observations, the F-test for the null hypothesis that the slope coefficient is equal to 0 is hear denoted Calculate R^2 and SEE Describe limitations of regression analysis Regression relations can change over time-> the issue of parameter instability Public knowledge of regression relationships may negate their future usefulness If the regression assumptions are violated, hypothesis tests and predictions based on linear regression will not be valid 9. Correlation and Regression - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 9. 29. Equity Valuation: Applicationsand Processes - An Overview Introduction Value Definition and Valuation Applications Communicating Valuation Results The Valuation Process 29. Equity Valuation. Applications and Processes - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 10. affects a company’sfuture cash flows -> equity The requirements are more specific in some situations. For e.g, regulations governing disclosures of conflicts and potential conflicts of interest vary across countries, investment recommendations are affected by policies of the firm employing an analyst 29. Equity Valuation: Applications and Processes - Part 1 Introduction Valuation The estimation of an asset’s value based on variables perceived to be related to future investment returns, on comparisons with similar assets, or on estimates of immediate liquidation proceeds Basic questions What is value? Who uses equity valuations? What is the importance of industry knowledge? How can the analyst effectively communicate his analysis? Value Definition and Valuation Applications Definition Intrinsic Value The value of the asset given a hypothetically complete understanding of the asset’s investment characteristics Reflects investor's view of the “true” or “real” value of an asset Grossman-Stiglitz paradox Market price and intrinsic value are identical Rational efficient markets formulation Investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative of accepting the market price Difficult to determine especially Common stock Trading costs exist Further room exists for price to diverge from value Analysts often view market prices both with respect and with skepticism Seek to identify mispricing A difference between the estimated intrinsic value and the market price of an asset Rely on price eventually converging to intrinsic value Recognize distinctions among the levels of market efficiency or tiers of markets Valuation is an inherent part to attempt positive excess risk adjusted returns (abnormal return or alpha) Uncertainty is constantly present Revaluate by looking for the presence of a particular market or corporate event ( catalyst) VE - P = (V - P) + (VE - V) VE = estimated value P = market price V = intrinsic value (V-P): the true mispricing, the difference between the true but unobservable intrinsic value V and the observed market price P Contribute to the abnormal return (VE-V): the difference between the valuation estimate and the true but unobservable intrinsic value The error in the estimate of the intrinsic value A useful estimate of intrinsic value Combine accurate forecasts and appropriate valuation model Expectational inputs used in valuation models Active security selection Manager’s expectations must differ from consensus expectations and be correct Going-Concern Value and Liquidation Value Going-concern assumption The assumption that the company will continue its business activities into the foreseeable future valuemaximizing using assets accessing its optimal sources of financing not appropriate for a company in financial distress The value added by assets working together and by human capital applied to managing those assets makes estimated goingconcern value greater than liquidation value Liquidation value Different time frame for liquidating causes different assets value of a company Orderly liquidation value Fair Market Value and Investment Value Fair market value is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell includes an assumption that both buyer and seller are informed of all material aspects of the underlying investment often used in valuation related to assessing taxes Investment value The concept of value to a specific buyer taking account of potential synergies and based on the investor’s requirements and expectations Valuation Applications Selecting stocks Primary use Inferring (extracting ) market expectations evaluate the reasonableness of the expectations as a benchmark or comparison value of the same characteristic for another company Evaluating corporate events A merger the general term for the combination of two companies An acquisition a combination of two companies, with one of the companies identified as the acquirer, the other the acquired the acquiring company’s own common stock is often used as currency for the purchase A divestiture a company sells some major component of its business A spin-off the company separates one of its component businesses and transfers the ownership of the separated business to its shareholders A leveraged buyout an acquisition involving significant leverage [i.e., debt], which is often collateralized by the assets of the company being acquired.) Rendering fairness opinions The parties to a merger may be required to seek a fairness opinion on the terms of the merger from a third party, such as an investment bank Evaluating business strategies and models Companies concerned with maximizing shareholder value evaluate the effect of alternative strategies on share value Communicating with analysts and shareholders Appraising private businesses for transactional purposes E.g acquisitions or buy-sell agreements for the transfer of equity interests among owners when one of them dies or retires, IPO,... Sharebased payment (compensation) Communicating Valuation Results Contents of a Research Report Kind of infor. intended readers seek to gain Sell-side analyst’s report: investment recommendation Persuasive supporting arguments The intrinsic value of the security The key assumptions and expectations underlying that estimated intrinsic value An update on the company’s financial and operating results A description of relevant aspects of the current macroeconomic and industry context An analysis and forecast for the industry and company Detailed historical descriptive statistics about the industry and company When a research report states a target price for a stock, it should clarify the basis for computing the target information on the uncertainty of reaching the target a time frame for reaching the target May be accompanied by an explanation of the underlying rationale Usual contents Specific forecasts A description of the valuation model Key valuation inputs A discussion of qualitative factors and other considerations that affect valuation Objectively address the uncertainty associated with investing in the security, and/or the valuation inputs involving the greatest amount of uncertainty Contains timely information is written in clear, incisive language is objective and well researched, with key assumptions clearly identified distinguishes clearly between facts and opinions contains analysis, forecasts, valuation, and a recommendation that are internally consistent presents sufficient information to allow a reader to critique the valuation states the key risk factors involved in an investment in the company discloses any potential conflicts of interests faced by the analyst Format of a Research Report Research Reporting Responsibilities All analysts have an obligation to provide substantive and meaningful content in a clear and comprehensive report format Analysts who are CFA Institute members, however, have an additional and overriding responsibility to adhere to the Code of Ethics and the Standards of Professional Conduct in all activities pertaining to their research reports The analyst must hold himself accountable to both standards of competence and standards of conduct An effective research report 29. Equity Valuation. Applications and Processes - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 11. The term “businessmodel” refers generally to how a company makes money Need sensitivity analysis 29. Equity Valuation: Applications and Processes - Part 2: The Valuation Process Understanding the business Industry and Competitive Analysis is to understand the basic characteristics of the markets served by a company and the economics of the company Use various frameworks Usefulness give appropriate attention to the most important economic drivers of a business to organize thoughts about an industry and to better understand a company’s prospects for success in competition with other companies in that industry to highlight the greatest challenges and opportunities need more sensitivity analysis ? How is a useful framework? Focus on these questions How attractive are the industries in which the company operates, in terms of offering prospects for sustained profitability Try to understand the industry structure Porter 5 forces Stay current on facts and news concerning all the industries What is the company’s relative competitive position within its industry, and what is its competitive strategy The level and trend of the company’s market share indicate its relative competitive position within an industry Corporate strategies Cost leadership Differentiation Focus How well has the company executed its strategy and what are its prospects for future execution Analyzing the company’s financial report to evaluate the company's strategic objectives' performances and develop expectations to it Historical analysis to have its insights through time Looking annual reports for 10, 5, 2 years prior 2 caveats merit mention importance of qualitative (non-numeric factors) avoid simply extrapolating past operating results when forecasting future performance Analysis of Financial Reports most relevant for evaluating a company’s success in implementing strategic choices Financial ratio analysis is useful for established companies Individual drivers of profitability for merchandising and manufacturing companies can be evaluated against the company’s stated strategic objectives Sources of Information Analysts can compare the information provided directly by companies to their own independent research Regulatory requirements concerning disclosures and filings vary internationally Be aware when regulations (e.g., Regulation FD in the United States) prohibit companies from disclosing material nonpublic information to analysts without also disseminating that information to the public Considerations in Using Accounting Information Quality of earnings analysis The scrutiny of all financial statements, including the balance sheet, to evaluate both the sustainability of the companies’ performance and how accurately the reported information reflects economic reality Also require careful scrutiny of accounting statements, footnotes, and other relevant disclosure Equity analysts: develop better insights into a company and improve forecast accuracy Sustainability of performance: identify aspects of reported nonrecurring performance Identify reporting decisions that may result in a level of reported earnings that are unlikely to continue comparison of a company’s net income with its operating cash flow A working selection of risk factors (AICPA 2002) (in case growth in an asset account at a much faster rate than the growth rate of sales Poor quality of accounting disclosures, such as segment information, acquisitions, accounting policies and assumptions, and a lack of discussion of negative factors. Existence of relatedparty transactions Existence of excessive officer, employee, or director loans High management or director turnover Excessive pressure on company personnel to make revenue or earnings targets, particularly when combined with a dominant, aggressive management team or individual Material non-audit services performed by audit firm Reported (through regulatory filings) disputes with and/or changes in auditors Management and/or directors’ compensation tied to profitability or stock price (through ownership or compensation plans). Although such arrangements are usually desirable, they can be a risk factor for aggressive financial reporting. Economic, industry, or companyspecific pressures on profitability, such as loss of market share or declining margins Management pressure to meet debt covenants or earnings expectations A history of securities law violations, reporting violations, or persistent late filings Forecasting Company Performance Two perspectives The economic environment Top-down forecasting Approach moves from international and national macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts Bottom-up forecasting Approach aggregates forecasts at a micro level to larger scale forecasts, under specific assumptions The company’s own operating and financial characteristics Consider qualitative as well as quantitative factors Selecting the Appropriate Valuation Model Absolute Valuation Models Def. a model that specifies an asset’s intrinsic value used to produce an estimate of value that can be compared with the asset’s market price The fundamental approach to equity valuation The value of an asset to an investor must be related to the returns that investor expects to receive from holding that asset. For common stock: Dividend discount models Analysts frequently define cash flows at the company level Free cash flow to equity model Defines cash flow net of payments to providers of debt Free cash flow to the firmDefines cash flows before those payments Residual income model Based on accrual accounting earnings in excess of the opportunity cost of generating those earnings Greater uncertainty than the case with bonds due to its CFs and discount rate need to address other issues, such as the value of corporate control or the value of unused assets Applied to bond valuationNot as uncertain as common stock A stream of cash payments specified in a legal contract (the bond indenture) A discount rate can usually be based on market interest rates and bond ratings Asset-based valuation Values a company on the basis of the market value of the assets or resources it controlsCan provide an independent estimate of value Relative Valuation Models Def. estimate an asset’s value relative to that of another assetUnderlying idea: similar assets should sell at similar prices How? using price multiples ratios of stock price to a fundamental such as cash flow per share P/E Undervalue Relatively undervalue enterprise multiples ratios of the total value of common stock and debt net of cash and shortterm investments to certain of a company’s operating assets to a fundamental such as operating earnings The more conservative investing strategies involve overweighting (underweighting) relatively undervalued (overvalued) assets, with reference to benchmark weights The more aggressive strategies allow short selling of perceived overvalued assets Relative value investing (or relative spread investing, if using implied discount factors) Pairs trading: buying the relatively undervalued stock and selling short the relatively overvalued stock Frequently involve a group of comparison assets The method of comparables is characterized by a wide range of possible implementation choices does not specify intrinsic value without making the further assumption that the comparison asset is fairly valued being simple, related to market prices, and grounded in a sound economic principle Valuation of the Total Entity and Its Components Sum-of-the-parts valuation Sums the estimated values of each of the company’s businesses as if each business were an independent going concern The value derived using a sum-of-the-parts valuation Breakup value or private market value When to use Value a company with segments in different industries that have different valuation characteristics evaluate the value that might be unlocked in a restructuring through a spinoff, splitoff, tracking stock, or equity (IPO) carveout Conglomerate discount The market applies a discount to the stock of a company operating in multiple, unrelated businesses compared to the stock of companies with narrower focuses Alternative explanation inefficiency of internal capital markets endogenous factors research measurement errors A breakup value in excess of a company’s unadjusted goingconcern value may prompt strategic actions such as a divestiture or spin-off Issues in Model Selection and Interpretation Criteria for model selection are that the valuation model be consistent with the characteristics of the company being valued having a good understanding of the business understanding the nature of its assets and how it uses those assets to create value appropriate given the availability and quality of data consistent with the purpose of valuation, including the analyst’s perspective Professionals frequently use multiple valuation models or factors in common stock selection Converting Forecasts to a ValuationTwo important aspects Sensitivity analysis to determine how changes in an assumed input would affect the outcome E.g when assess how a change in assumptions about a company’s future growth or analyze how different competitive responses would affect the forecasted financials and the estimated valuation Situational adjustments control premiumsthe value of a stock investment lack of marketability discountsthe value of nonpublicly traded stocks illiquidity discounts the prices of shares with less depth to their markets an investor wishes to sell an amount of stock that is large relative to that stock’s trading volume (assuming it is not large enough to constitute a controlling ownership) blockage factor The price that would be lower than the market price for a smaller amount of stock Applying the Valuation Conclusion: The Analyst’s Role and Responsibilities The purposes and the intended consumer of the valuation Valuation judgments to distribute to current and prospective retail and institutional brokerage clients Sell-side analyst: Analysts who work at brokerage firms Valuation judgments to a portfolio manager or to an investment committee as input to an investment decision Buy-side analysts Investment discipline (security selection) and quantitative investment disciplines Both corporate analysts and investment bank analysts may also identify and value companies that could become acquisition targets Analysts at independent vendors of financial information usually offer valuation information and opinions in publicly distributed research reports Investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, and in some contexts, recommending appropriate investment actions based on sound analysis Help their clients achieve their investment objectives Contribute to the efficient functioning of capital markets Benefit the suppliers of capital, including shareholders, when they are effective monitors of management’s performance Present value models (discounted CF models) 29. Equity Valuation. Applications and Processes - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 12. http://waytofinancesuccess.com WAY TO FINANCESUCCESS- Website: http://waytofinancesuccess.com To be continued… For MORE CFA® Mind Maps, please go to:http://waytofinancesuccess.com
- 13. 39. Private Real EstateInvestments: An Overview INTRODUCTION REAL ESTATE INVESTMENT: BASIC FORMS REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS THE COST AND SALES COMPARISON APPROACHES TO VALUATION OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE THE INCOME APPROACH TO VALUATION RECONCILIATION DUE DILIGENCE VALUATION IN AN INTERNATIONAL CONTEXT INDICES PRIVATE MARKET REAL ESTATE DEBT 39. Private Real Estate Investments - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 14. 39. Private RealEstate Investments - Part 1 INTRODUCTION Private equity investment: sometimes referred to as direct ownership often included in the portfolios of investors with long-term investment horizons and with the ability to tolerate relatively lower liquidity Publicly traded debt investment: sometimes referred to as indirect lending suitable for investors with short investment horizons and higher liquidity needs REAL ESTATE INVESTMENT: BASIC FORMS Investment in real estate has been defined from a capital market perspective in the context of quadrants which are a result of two dimensions of investment The first dimension: whether the investment is made in the private or public market The second dimension: whether the investment is made in the private or public market Four quadrants Private real estate investment, compared with publicly traded real estate investment, typically involves larger investments because of the indivisibility of real estate property and is more illiquid Publicly traded real estate investment allows the real estate property to remain undivided but the ownership or claim on the property to be divided Equity investors generally expect a higher rate of return than lenders (debt investors) because they take on more risk Debt investors in real estate, whether through private or public markets, expect to receive their return from promised cash flows and typically do not participate in any appreciation in value of the underlying real estate REAL ESTATE: CHARACTERISTICS AND CLASSIFICATIONS Characteristics Heterogeneity and fixed location High unit value Management intensive High transaction costs Depreciation Need for debt capital Illiquidity: Price determination Residential properties: single-family houses and multi-family properties, properties that provide housing for individuals or families Single-family properties may be owner-occupied or rental properties Multi-family properties are rental properties even if the owner or manager occupies one of the units Multifamily housing is usually differentiated by location and shape of structure Commercial real estate properties Properties purchased with the intent to let, lease, or rent Office Industrial and warehouse Retail Hospitality Other types PRIVATE MARKET REAL ESTATE EQUITY INVESTMENTS Motivations Current income Price appreciation (capital appreciation) Inflation hedge Diversification Tax Benefits Risk Factors Characteristic sources of risk or risk factors of real estate investment Business conditions Long lead time for new development Cost and availability of capital Unexpected inflation Demographics Lack of liquidity Environmental Availability of information Management Leverage Other risk factors Real Estate Risk and Return Relative to Stocks and Bonds Risk and return of equity real estate investments is affected by the characteristics of real estate and the risk factors, structure of leases between the owner and tenants Commercial Real Estate Office The demand for office depends heavily on employment growth The average length of an office building lease varies globally An important consideration in office leases is whether the owner or tenant incurs the risk of operating expenses “net lease” requires the tenant to be responsible for paying operating expenses “gross lease” requires the owner to pay the operating expenses Not all office leases are structured as net or gross leases There are differences in how leases are structured over time and in different countries Industrial and Warehouse The demand for industrial and warehouse space is heavily dependent on the overall strength of the economy and economic growth and on import and export activity in the economy Retail The demand depends heavily on trends in consumer spending. Consumer spending, in turn, depends on the health of the economy, job growth, population growth, and savings rates “Percentage lease”: the requirement that the tenants pay additional rent once their sales reach a certain level The lease will typically specify a “minimum rent” that must be paid regar dless of the tenant’s sales and the basis for calculating percentage rent once the tenant’s sales reach a certain level or breakpoint Multi-Family The demand for multi-family space depends on population growth, especially for the age segment most likely to rent apartments how the cost of renting compares with the cost of owning-that is, the ratio of home prices to rents THE COST AND SALES COMPARISON APPROACHES TO VALUATION The Cost Approach Types of depreciation Physical deterioration related to the age of the property because components of the property wear out over time. Two types curable: fixing the problem will add value that is at least as great as the cost of the cure incurable: Fixing a structural problem with the foundation of the building may cost more to cure than the amount that it would increase the value of the property if cured Functional obsolescence: a loss in value due to a design that is different from that of a new building constructed with an appropriate design for the intended use of the property External obsolescence: due to either the location of the property or economic conditions, results when the location is not optimal for the property Locational obsolescence results when the location is not optimal for the property Economic obsolescence results when new construction is not feasible under current economic conditions The Sales Comparison Approach The sales comparison approach implicitly assumes that the value of a property depends on what other comparable properties are selling for in the current market Advantages and Disadvantages of the Cost and Sales Comparison Approaches OVERVIEW OF THE VALUATION OF COMMERCIAL REAL ESTATE Appraisals Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties Value Market value: can be thought of as the most probable sale price. It is what a typical investor is willing to pay for the property There are other definitions of value that differ from market value Investment value: the value to a particular investor, could be higher or lower than market value depending on the particular investor’s motivations and how well the property fits into the investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on. Value in use: the value to a particular user Introduction to Valuation Approaches Three different approaches The income approach considers what price an investor would pay based on an expected rate of return that is commensurate with the risk of the investment The cost approach considers what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised (referred to as the subject property ) The sales comparison approach considers what similar or comparable properties (comparables) transacted for in the current market Highest and Best Use Highest and best use: the use that would result in the highest value for the land The cost approach involves estimating the value of the building(s) based on adjusted replacement cost The replacement cost is adjusted for different types of depreciation (loss in value) to arrive at a depreciated replacement cost Non-residential properties include commercial properties other than multifamily properties, farmland, and timberland 39. Private Real Estate Investments - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com Classifications
- 15. 39. Private RealEstate Investments - Part 2 THE INCOME APPROACH TO VALUATION General Approach and Net Operating Income There are two income approaches the direct capitalization method capitalizes the current NOI using a growth implicit capitalization rate When the capitalization rate is applied to the forecasted first-year NOI for the property, the implicit assumption is that the first-year NOI is representative of first-year NOI would be for similar properties the DCF method applies an explicit growth rate to construct an NOI stream from which a present value can be derived Income can be projected either for the entire economic life of the property or for a typical holding period with the assumption that the property will be sold at the end of the holding period Calculating NOI Rental income at full occupancy + Other income (such as parking) = Potential gross income (PGI) – Vacancy and collection loss = Effective gross income (EGI) – Operating expenses (OE) = Net operating income (NOI) The Capitalization Rate and the Discount Rate The cap rate is like a current yield for the property whereas the discount rate is applied to current and future NOI Cap rate = Discount rate - Growth rate Defining the Capitalization Rate Cap rate = NOI/Value going-in cap rate is used to clarify that it is based on the first year of ownership when the investor is going into the deal terminal cap rate is based on expected income for the year after the anticipated sale of the property Value = NOI/Cap rate observing what other similar or comparable properties are selling for to know the cap rate Cap rate = NOI/Sale price of comparable Market value = Rent/ARY ARY: all risks yield Stabilized NOI If NOI is not representative of the NOI of similar properties because of a temporary issue, the subject property's NOI should be stabilized Other Forms of the Income Approach Gross income multiplier: the ratio of the sale price to the gross income expected from the property in the first year after sale The problem of gross income multipler: not explicitly consider vacancy rates and operating expenses The Discounted Cash Flow (DCF) Method The Relationship between Discount Rate and Cap Rate If the growth rate is constant V = NOI/(r – g) If NOI is not expected to grow at a constant rate, then NOIs are projected into the future and each period’s NOI is discounted to arrive at a value of the property The Terminal Capitalization Rate The cap rate used to estimate the resale price or terminal value is referred to as a terminal cap rate or residual cap rate It is a cap rate that is selected at the time of valuation to be applied to the NOI earned in the first year after the property is expected to be sold to a new buyer The terminal cap rate could be the same, higher, or lower than the goingin cap rate depending on expected discount and growth rates at the time of sale If interest rates are expected to be higher in the future => terminal cap rates might be higher The growth rate is often assumed to be a little lower => a slightly higher terminal cap rate Uncertainty about what the NOI will be in the future may also result in selecting a higher terminal cap rate Adapting to Different Lease Structures Lease structures vary across locales and can have an effect on the way value is typically estimated in a specific locale The Equivalent Yield The “equivalent yield” is a single discount rate that could be applied mathematically to both income streams that would result in the same value Advanced DCF: Lease-by-Lease Analysis The general s teps to a DCF analysis are as follows Project income from existing leases Make assumptions about lease renewals Assumptions also have to be made about what will happen when a lease comes up for renewal—often referred to as market leasing assumptions Make assumptions about operating expenses Operating expenses involve items that must be paid by the owner, such as property taxes, insurance, maintenance, management, marketing, and utilities Make assumptions about capital expenditures such as a new heating and air conditioning system or replacing a roof, etc., Make assumptions about absorption of any vacant space Estimate resale value (reversion) how long the property will be held by the initial investor Select discount rate to find PV of cash flows Advantages and Disadvantages of the Income Approach Advantage: it captures the cash flows that investors actually care about Disadvantage is the amount of detailed information that is needed and the need to forecast what will happen in the future even if it is just forecasting a growth rate for the NOI and not doing a detailed lease-by-lease analysis Common Errors The discount rate does not reflect the risk Income growth is greater than expense growth The terminal cap rate is not logical compared with the implied going-in cap rate The terminal cap rate is applied to an income that is not typical The cyclical nature of real estate markets is not recognized RECONCILIATION Three different approaches to valuation: the income, cost, and sales comparison approaches may produce the different answers due to imperfections in the data and inefficiencies in the market The appraiser needs to reconcile the differences and arrive at a final conclusion about the value The purpose of reconciliation is to decide which approach or approaches you have the most confidence in and come up with a final estimate of value In an active market: sales comparison approach is preferred When there are fewer transactions: income approach is preferred DUE DILIGENCE To verify other facts and conditions that might affect the value of the property and that might not have been identified by the appraiser E.g Review the leases for the major tenants and review the history of rental payments and any defaults or late payments. Get copies of bills for operating expenses, such as utility expenses. Look at cash flow statements of the previous owner for operating expenses and revenues. Have an environmental inspection to be sure there are no issues, such as a contaminant material on the site. Have a physical/engineering inspection to be sure there are no structural issues with the property and to check the condition of the building systems, structures, foundation, and adequacy of utilities. Have an attorney or appropriate party review the ownership history to be sure there are no issues related to the seller’s ability to transfer free and clear title that is not subject to any previously unidentified liens. Review service and maintenance agreements to determine whether there are recurring problems. Have a property survey to determine whether the physical improvements are in the boundary lines of the site and to find out if there are any easements that would affect the value. Verify that the property is compliant with zoning, environmental regulations, parking ratios, and so on. Verify that property taxes, insurance, special assessments, and so on, have been paid VALUATION IN AN INTERNATIONAL CONTEXT INDICES Appraisal-Based Indices Disadvantages Appraisal lag May not capture the price increase until a quarter or more after it was reflected in transactions Tend to smooth the index, have lower correlation with others => allocation to real estate would likely overestimated How to adjust: unsmooth” the appraisalbased or use a transactionbased index when comparing real estate with other asset classes Transaction-Based Indices In recent years, indices have been created that are based on actual transactions rather than appraised values Two main ways A repeat sales index relies on repeat sales of the same property A hedonic index which requires only one sale Disadvantages Include random elements in the observations => may be upward or downward movements from quarter to quarter that are somewhat random PRIVATE MARKET REAL ESTATE DEBT The maximum amount of debt that an investor can obtain on commercial real estate is usually limited by either the ratio of the loan to the appraised value of the property (loan to value or LTV) or the debt service coverage ratio (DSCR) The debt service coverage ratio is the ratio of the firstyear NOI to the loan payment DSCR = NOI/Debt service The Direct Capitalization Method 39. Private Real Estate Investments - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com Return = {NOI Capital expenditures + (Ending market value Beginning market value )}/Beginning market value
- 16. 48. Futures Marketsand Contracts: An Overview FUTURE CONTRACTS FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT WHY FORWARD AND FUTURES PRICES DIFFER MONETARY & NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES 48. Futures Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 17. should be thesame as that of a forward contract 48. Futures Markets and Contracts - Part 1 FUTURE CONTRACTS Similar to forward contracts in Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date Cash settlement contracts are settled by paying the contract value in cash on the expiration date Both forwards and futures are priced to have zero value at the time the investor enters into the contract Different from forward contracts Futures are marked to market at the end of every trading day. Forward contracts are not marked to market Futures contracts trade on organized exchanges. Forwards are private contracts and do not trade on organized exchanges Futures contracts are highly standardized. Forwards are customized contracts satisfying the needs of the parties involved Forwards are contracts with the originating counterparty; a specialized entity called a clearinghouse is the counterparty to all futures contracts Forward contracts are usually not regulated. The government having legal jurisdiction regulates futures markets FUTURES PRICE & THE VALUE OF A FUTURES CONTRACT Futures price must converge to the spot price at expiration At expiration, the spot price must equal the futures price because the futures price has become the price today for delivery today, which is the same as the spot. Arbitrage will force the prices to be the same at contract expiration Future margins and marking to market Futures margin is a performance guarantee The clearinghouse guarantees that traders in the futures market will honor their obligations by splitting each trade once it is made and acting as the opposite side of each position => To safeguard the clearinghouse, both sides of the trade are required to post margin and settle their accounts on a daily basis Marking to market is the process of adjusting the margin balance in a futures account each day for the change in the value of the contract from the previous trading day, based on the settlement price Value of a futures contract Has no value at contract initiation Does not accumulate value changes over the term of the contract. The value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero The futures price at any point in time is the price that makes the value of a new contract equal to zero The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market Value of futures contract = current futures price - previous mark-to-market price If the futures price increases, the value of the long position increases WHY FORWARD AND FUTURES PRICES DIFFER The no-arbitrage price of a futures contract FP = futures price So = spot price at inception of the contract ( t = 0) Rf = annual risk-free rate T = futures contract term in years Cases that causes futures and forward prices to be different If investors prefer the mark-to-market feature of futures, futures prices will be higher than forward prices If investors would rather hold a forward contract to avoid the marking to market of a futures contract, the forward price would be higher than the futures price Future arbitrage Cash-and-carry arbitrage A cash-and-carry arbitrage consists of buying the asset, storing/holding the asset, and selling the asset at the futures price when the contract expires Steps At the initiation of the contract Borrow money for the term of the contract at market interest rates Buy the underlying asset at the spot price Sell (go short) a futures contract at the current futures price At contract expiration Deliver the asset and receive the futures contract price Repay the loan plus interest If the futures contract is overpriced => generate a riskless profit The futures contract is overpriced if the actual market price is greater than the no-arbitrage price Reverse cash-and-carry arbitrage When the futures price is too low (which presents a profitable arbitrage opportunity) Steps At the initiation of the contract Sell the asset short Lend the short sale proceeds at market interest rates Buy (go long) the futures contract at the market price At contract expiration Collect the loan proceeds Take delivery of the asset for the futures price and cover the short sale commitment 48. Futures Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 18. 48. Futures Markets andContracts - Part 2 MONETARY AND NONMONETARY BENEFITS AND COSTS ASSOCIATED WITH HOLDING THE UNDERLYING ASSET AND THEIR EFFECTS TO FUTURES PRICE Any positive costs associated with storing or holding the asset in a cash and carry arbitrage will increase the no-arbitrage futures price A monetary benefit from holding the asset will decrease the no-arbitrage futures price E.g., Financial assets: no storage costs other than the opportunity cost of the funds Convenience yield: The return from non-monetary benefits which come from holding an asset in short supply The no-arbitrage futures price counting net costs net costs (NC) = storage costs - convenience yield FV (NC)= future value, at contract expiration, of the net costs of holding the asset The no-arbitrage futures price counting net benefits NB = yield on the asset + convenience yield FV (NB) = future value, at contract expiration, of the net benefits of holding the asset THE RELATION BETWEEN FUTURES PRICES AND EXPECTED SPOT PRICES Backwardation and contago Backwardation refers to a situation where the futures price is below the spot price to occur, there must be a significant benefit to holding the asset, either monetary or non-monetary E.g., benefits to holding the asset that offset the opportunity cost of holding the asset (the risk-free rate) and additional net holding costs Contango refers to a situation where the futures price is above the spot price happens when there is no benefits to holding the asset, the futures price will be If both parties to a futures transaction are hedging existing risk, the futures price may be equal to expected future spot prices The futures price might be temporarily above or below expected future spot prices, but it would be an unbiased predictor of future spot rates Normal backwardation happens when the futures price is lower than the expected price in the future to compensate the future buyer for accepting asset price risk Normal contango happens when the futures price is greater than the expected spot price The most likely situation in financial markets is normal backwardation Eurodollar, Treasury Bonds, Stock Index, and Currency Futures Eurodollar similar to a forward rate agreement to lend US$1,000,000 for three months beginning on the contract settlement date based on 90-day LIBOR, which is an add-on yield the price quotes are calculated as (100 - annualized LIBOR in percent) the minimum price change is one "tick," which is a price change of 0.0001 = 0.01 % Treasury Bonds traded for T-bonds with a maturity of 15 years or more the contract is deliverable with a face value of $100,000 T-bond futures are quoted as a percent and fractions of 1 % (measured in 1/32nds) of face value each bond is given a conversion factor (multiplier) that is used to adjust the long's payment at delivery Stock index futures based on the level of an equity index most popular stock index future is the S&P 500 settlement is in cash and is based on a multiplier of 250 Currency Futures In the United States, currency contracts trade on the euro, Mexican peso, and yen, among others Treasury Bill Futures Pricing Treasury bill (T-bill) futures contracts are based on a $1 million face value 90-day (13-week) T-bill, and they settle in cash The price quotes are 100 minus the annualized discount in percent on the T-bills T-bill futures are priced using the no-arbitrage principle PRICING EURODOLLAR FUTURES, TREASURY BOND FUTURES, STOCK INDEX AND CURRENCY FUTURES Eurodollar futures Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield => The result is that the deposit value is not perfectly hedged by the Eurodollar contract => Eurodollar futures can't be priced using the standard no-arbitrage framework Treasury Bond Futures The no-arbitrage futures price for a T-bond contract FVC: the future value of the coupon payments The futures price that insures a cash-and-carry arbitrage would provide no profit is lower than without the cash flows Because the cost to hold the asset is reduced by the asset cash flows T-bond futures prices must be adjusted to conform to the price for the bond that is cheapest to deliver, using its conversion factor (CF) Stock futures The no-arbitrage futures price adjusted for the future value of the dividends (FVD) or present value of the dividends (PVD) Equity Index Futures The no-arbitrage futures price Currency Futures The price of currency futures DC = domestic currency FC = foreign currency In continuous time it is 48. Futures Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 19. 49. Option Marketsand Contracts: An Overview PUT-CALL PARITY FOR EUROPEAN OPTIONS SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL) THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONS AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS 49. Option Markets and Contracts - Overview - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 20. 49. Option Markets andContracts - Part 1 PUT-CALL PARITY FOR EUROPEAN OPTIONS A fiduciary call A long position in a European call option with an exercise price of X that matures in T years on a stock (with a price at time t of S t) A long position in a pure-discount riskless bond that pays X in T years A protective put A long position in a European put option with an exercise price of X that matures in T years A long position in the underlying stock SYNTHETIC CALL/PUT OPTION, BOND AND UNDERLYING STOCK That the cost of a fiduciary call must be equal to the cost of a protective up +: long position - : short position A synthetic European call option is formed by Buying a European put option on the same stock with the same exercise price (X) and the same maturity (T) Buying the stock Shorting (i.e., borrowing) the present value of X worth of a pure-discount riskless bond A synthetic European put option is formed by Buying a European call option Shorting the stock Buying (i.e., investing in) the discount bond A synthetic stock position is formed by Buying a European call option Shorting (i.e., writing) a European put option Buying (i.e., investing in) the discount bond A synthetic pure-discount riskless bond is created by Buying a European put option Buying the stock Shorting (i.e., writing) a European call option Two reasons to create synthetic positions in the securities To price options by using combinations of other instruments with known prices To earn arbitrage profits by exploiting relative mispricing among the four securities Using put-call parity for arbitrage If put-call parity doesn't hold (if the cost of a fiduciary call does not equal the cost of a protective put), buy (go long in) the underpriced position and sell (go short) in the overpriced position ONE- AND TWO-PERIOD BINOMIAL MODELS TO CALCULATE AND INTERPRET PRICES OF INTEREST RATE OPTIONS AND OPTIONS ON ASSETS One-Period Binomial Model D=risk-neutral probability of an down-move = 1 - U Rf = risk-free rate U = size of an up-move D = size of a down-move Calculate the value of an option on the stock Calculating the payoff of the option at maturity in both the up-move and down-move states Calculating the expected value of the option in one year as the probability-weighted average of the payoffs in each state Discounting the expected value back to today at the risk-free rate Arbitrage with one-period binomial model provides the information required to calculate a hedge ratio (the fractional share of stock in the arbitrage trade) Two-Period Binomial Model Steps to value an option Calculate the stock values at the end of two periods (there are three possible outcomes because an up-then-down move gets you to the same place as a down-then-up move) Calculate three possible option payoffs at the end of two periods Calculate the expected option values at the end of two periods (t = 2) using the up-and down-move probabilities Discount the expected option values (t = 2) back one period at the risk-free rate to find the option values at the end of the first period (t = 1) Calculate the expected option value at the end of one period (t = 1) using up-and down-move probabilities Discount the expected option value at the end of one period (t = 1) back one period at the risk-free rate to find the option value today Binomial interest rate trees is the set of possible interest rate paths that are used to value bonds with a binomial model the underlying rule governing the construction of an interest rate tree the values for on-the-run issues generated using an interest rate tree should prohibit arbitrage opportunities the interest rate tree must maintain the interest rate volatility assumption of the underlying model Options on Fixed Income Securities There are three basic steps to valuing an option on a fixed-income instrument using a binomial tree price the bond at each node using projected interest rates calculate the intrinsic value of the option at each node at maturity of the option, and calculate the value of the option today Options on Interest Rates: Caps and Floors The value of an interest rate cap or floor is the sum of the values of the individual caplets or floorlets Expiration value of caplet Expiration value of floorlet As the period covered by a binomial model is divided into arbitrarily small, discrete time periods, the model results converge to those of the continuous-time model ASSUMPTIONS UNDERLYING THE BLACK-SCHOLES-MERTION MODEL The Black-Scholes-Merton (BSM) model values options in continuous time and is derived from the same no-arbitrage assumption used to value options with the binomial model To derive the BSM model, an "instantaneously" riskless portfolio is used to solve for the option price based on the same logic Assumptions and Limitations The price of the underlying asset follows a lognormal distribution The (continuous) risk-free rate is constant and known Limitation: The BSM model is not useful for pricing options on bond prices and interest rates The volatility of the underlying asset is constant and known In practice, the volatility is not known and must be estimated. The bigger problem is that volatility is often not constant over time and the BSM model is not useful in these situations Markets are "frictionless" Model is less realistic and less useful The underlying asset generates no cash flows The BSM model can be easily altered if we relax the assumption of no cash flows on the underlying asset The options are European The model does not correctly price American options. Binomial option pricing models are more appropriate for pricing American options The formula for the BSM model Use put-call parity to calculate the put value Put-call parity for European options 49. Option Markets and Contracts - Part 1 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 21. 49. Option Markets andContracts - Part 2 A CHANGE IN THE VALUE OF EACH INPUT AFFECTS THE OPTION PRICE (UNDER THE BLACK-SCHOLES-MERTION MODEL) A Greek is a sensitivity factor that captures the relationship between each input (asset price, asset price volatility, time to expiration, and the risk-free rate) the option price Delta describes the relationship between asset price and option price Vega measures the sensitivity of the option price to changes in the volatility of returns on the underlying asset Rho measures the sensitivity of the option price to changes in the risk-free rate Theta measures the sensitivity of the option price to the passage of time theta is less than zero: as time passes and the option approaches the maturity date, its value decreases THE DELTA OF AN OPTION AND ITS USE IN DYNAMIC HEDGING Delta is the change in the price of an option for a one-unit change in the price of the underlying security C = change in the price of the call over a short time interval S = change in the price of the underlying stock over a short time interval Use BSM model to estimate the change in the value of the call given the change in the value of the stock and the option's delta C N(d1) x S P (change in put price) [N(d1) - 1] x S Interpreting Delta A call option delta is between 0 and 1. If the call option is Out-of-the-money (stock price is less than exercise price), the call delta moves closer to 0 as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is greater than exercise price), the call delta moves closer to 1 as time passes, assuming the underlying stock price doesn't change A put option delta is between -1 and 0. If the put option is Out-of-the-money (stock price is greater than exercise price), the put delta moves closer to O as time passes, assuming the underlying stock price doesn't change In-the-money (stock price is less than exercise price), the put delta moves closer to -1 as time passes, assuming the underlying stock price doesn't change Dynamic Hedging The goal of a delta-neutral portfolio (or delta-neutral hedge) is to combine a long position in a stock with a short position in a call option so that the value of the portfolio does not change when the value of the stock changes Number of call options needed to delta hedge = number of shares hedged/delta of call option Number of put options needed to delta hedge = number of shares/delta of the put option The delta-neutral position only holds for very small changes in the value of the underlying stock => must be continually rebalanced to maintain the hedge (a dynamic hedge) costly in terms of transaction costs Gama effect Gamma measures the rate of change in delta as the underlying stock price changes can be viewed as a measure of how poorly a dynamic hedge will perform when it is not rebalanced in response to a change in the asset price Call and put options on the same underlying asset with the same exercise price and time to maturity will have equal gammas Long positions in calls and puts have positive gammas Gamma is largest when a call or put option is at-the-money and close to expiration EFFECT OF THE UNDERLYING ASSET'S CASH FLOWS ON THE PRICE OF AN OPTION All else equal, the existence of cash flows on the underlying asset will Decrease the value of a call option Increase the value of a put option Put-call parity for options on underlying assets with cash flows by adjusting S for the present value of the cash flows (PVCF) THE HISTORICAL AND IMPLIED VOLATILITIES OF AN UNDERLYING ASSET The steps in computing historical volatility for use as an input in the BSM continuous-time options pricing model are Step 1: Convert a time series of N prices to returns Step 2: Convert the returns to continuously compounded returns Step 3: Calculate the variance and standard deviation of the continuously compounded returns Implied volatility is the value for standard deviation of continuously compounded rates of return that is "implied" by the market price of the option when used in the Black-Scholes formula, it produces the current market price of the option PUT-CALL PARITY FOR FORWARD/FUTURES OPTIONSPut-call parity for options on forwards and futures is as follows American options on futures are more valuable than European options because early exercise provides mark to market funds on the futures, which can earn interest Americans and European options on forward contracts are equivalent because there is no mark to market AMERICAN/EUROPEAN OPTIONS ON FUTURES AND FORWARDS AND APPROPRIATE PRICING MODEL FOR EUROPEAN OPTIONS There is a benefit to early exercise of options on futures when they are deep in the money Exercising the option (either a put or call) early will generate cash from the mark to market => cash can earn interest, while the futures position will gain or lose from movements in the futures price => these price movements between early exercise and option expiration will mirror those of the deep in the money option With no reason for early exercise, the value of American and European options on forwards are the same There is no mark to market on forwards, early exercise does not accelerate the payment of any gains The Black model can be used to price European options on forwards and futures = standard deviation of returns on the futures contract FT = futures price American options on futures are more valuable than comparable European options because 49. Option Markets and Contracts - Part 2 - CFA Mind Maps Level 2 - 2016 - Copyright by WAY TO FINANCE SUCCESS WAY TO FINANCE SUCCESS - Website: http://waytofinancesuccess.com
- 22. http://waytofinancesuccess.com WAY TO FINANCESUCCESS- Website: http://waytofinancesuccess.com To be continued… For MORE CFA® Mind Maps, please go to:http://waytofinancesuccess.com