Derivates Completed

I’m done with this part. I found the Swaps chapter to be a little confusing. Even the one on Credit Default Swaps was totally new and took me some time to understand. I’ll need to keep revising the formulas. Other than that, futures, forwards, options…etc. were quite okay for me.

I’m starting Quants tomorrow and hope to get done with it by this weekend.

Delurkers, Come Out!

I didn’t do any studies today, except for a couple of problems. So, no way that I’m going to complete everything by tomorrow. Ha!

Because of that, I’m pissed off. The stats of this blog has been rising steadily and the funny thing is that not many of you people who are reading this post now take the time to comment!

So if you’re reading my blog, it would be great if you could come out and comment. Thanks!

Quick Update on PM

Allright! Three cheers for me 😀 Just got done with Port. Management. However, I’m thinking of spending this day finishing off some problems based on Treynor Black Model, because of which lots of people got screwed last June. I plan to post some notes on this part and Reading 68 (which I’d not done before) today. I also want to re-visit Reading 68 using the Curriculum. Tomorrow onwards, I’m going to start off with Derivatives. Technically, I’m supposed to finish it by 1/31. That gives me only four days…kinda impossible…but might not be, because I took a look at the topics, and I already know half of them, thanks to my Derivatives course in MBA. So, let’s hope for the best.

I really really need to finish off Econ, Stats and Fixed Income by the end of Feb, so that I can revise and re-revise for the remaining three months…which I’ll badly need (because I don’t remember much).

Think I’ve been rambling too much. Any of you reading this- please feel free to comment and let me know about your progress.

Reading 70: International Asset Pricing

I’m going to cover only the first part of the reading here. Btw, you might want to study from the Official Curriculum the entire Portfolio Management portion. Schweser sucks, at least for this part. I found several rounding and formula errors while studying this reading. So…just a small warning.

1. International markets are integrated and efficient if the securities with the same risk characteristics have the same expected return all over the world.

They are segmented and inefficient if the securities with similar characteristics sell at different exchange rate- adjusted prices in different countries, thus violating the law of one price. This is often the case when we deal with emerging markets.

There are six impediments to international capital mobility- Psychological barriers, legal restrictions, transaction costs, discriminatory taxation against foreign income, political risks and foreign exchange risks.

Intl. integration requires only a sufficient flow of capital to make the world market efficient and to eliminate mispricing among countries.

2. Expected return on an unhedged foreign investment:

E(R)= E(Rfc)+ s, where E(R)= expected return in DC , E(Rfc)= Expected return in FC and s= appreciate/depr, calculated as (S1-S0)/S0

OR

E(R)=R(dc) +FCRP, Rdc= risk free domestic interest rate and FCRP= Foreign currency risk premium. (Take a look at #7 regarding how to calculate FCRP)

Expected return on a hedged foreign investment:

E(R)=E(Rfc)+ (F-s)/s, where F= Locked in forward rate

Both F and S are DC/FC. (F-S)/S is the forward risk premium/discount, which can be found out from the Interest Rate Parity Equation: F=(S*(1+rDC))/(1+rFC) or approx, (F-S)/S= (Rdc-Rfc).

3. Extended CAPM is the domestic CAPM, with the domestic Rf as the Rf rate and the market portfolio is composed of all the risky assets of the world.

4. This extension of CAPM can be justified with addl. two more assumptions:

a. Investors throughout the world have identical consumption baskets

b. PPP holds (the real prices of consumptions goods are identical across countries).

5. Real exchange rate (X)= (S dc/fc)(P fc/dc), where S= nominal exchange rate and P= Price level

6. Also, x (real rate) = s- (Idc-I fc) , where s= change in nominal rate and (I dc- I fc) = inflation differential rate. If PPP holds, then, x=0% and the nominal exchange rate movement (DC/FC) = Inflation rate differential. If this doesn’t happen, then any such real exchange rate movement (means nominal rate movement that is not explained by the inflation % change) would violate the assumptions supporting the domestic CAPM extension, which is the same as real foreign exchange currency risk.

Hence, in the absence of real exchange currrency risk, CAPM extension holds, otherwise not!

Part II (01/25/08)

7. FCRP (Foreign Currency Risk Premium) is calculated as: E(s)- (Rdc-Rfc), where E(s)= (S1-So)/S0 or the currency appreciation/depreciatio; and (Rdc-Rfc) is the approx. forward premium or discount. Alternate method: [E(S1)-F]/S0

8. Since PPP does not always hold in the real world, we need to use the International CAPM Model (ICAPM), which is almost the same as domestic CAPM, except that it also factors in the FCRP and the sensitivity to each FCRP (gamma).

Limitation: Applies only to an integrated world capital market with currency hedging available.

9. Other forms of market imperfections and constraints cannot be easily integrated with the equilibrium asset pricing framework.

10. Local currency exposure measures the sensitivity of the local asset return to the local currency value and is found by time series regression. Can either be zero correlation (no relation between return and value), negative correlation (value of the currency increases, then the stock return decreases), or positive correlation (both currency value and the stock return increase).

11. For an investor, the domestic currency exposure= 1+ local currency exposure. It only depends upon the value of the local currency and not the local asset return.

12. If exchange rate movements only reflect inflation rate differentials , that is PPP holds, then there is no specific influence on the economy. Real exchange rate movements, however, have an impact on the equity prices, depending on currency exposures.

13. Two models for explaining the effect of the exchange rate movement on the domestic economic activity:

The traditional model: A decline in real exchange rate for a country creates problems in the short term, because the trade deficit increases –>GNP decreases because imports become costly, production cost increases etc. –> eventually offset by the improved international competitiveness and export demand until PPP is restored. Thus, the traditional model predicts a negative currency exposure.

The Money Demand Model: Predicts a positive currency exposure. An increase in the real exchange rate of the country will cause in increase in the stock returns because of the increase in the currency demand.

Caution: A drop in the value of an emerging market’s currency is often a signal that the country is running into severe problems.

14. Currency Exposure for Bonds: There are two models again-

a. The Free Market Model– Predicts a negative currency exposure. Increase in real interest rate will cause an increase in the currency value, but the bond price will go down.

b. The Govt. Intervention Method (Leaning against the Wind)– Predicts a positive currency exposure. Increase in the stock price will make the Govt . reduce the real interest rates, thus inflating the bond prices.

15. Currency Exposure of Individual Firms- Can be estimated by regressing the company’s stock’s returns against market returns and currency returns. Can be fine tuned by a detailed analysis of the source of sales, profit margins , costs, geographical origin of the sales, costs etc.

Level-I results for December 2007 Just Declared

Lots of people whom I know from the Analyst Forum cleared it. This comes at the right time…just when I started losing my interest. It has brought me back to the “CFA World” with a jolt and my interest in those romantic books has been renewed.

Expect some sexy action here! CFA Insti- Watch out for me.

Reading 54: Hedge Fund Risks and How to Manage Them

There are three types of hedge fund risks: Investment risks, fraud risks and operational risks.

Investment risks: Risks due to the nature of the markets, manager styles,strategies, securities held and derivatives used. Note that a manager’s style does not necessarily define the risks, as two managers pursuing the same style can have very different strategies and risks..

Limited Information on Hedge Fund Risk- Unfortunately, most data for hedge funds only goes back to as far as the late 1980s or early 1990s. This was a stable period in the hedge fund history and so it is difficult to forecast the future risks.

Credit spreads and fixed income funds- The largest factor here is the widening of credit spreads.

Equity Market Risk and Fixed Income Funds-

Widening credit spreads, declines in the stock market and losses at fixed income hedge funds are correlated to one another. This is because most FI hedge funds are short treasury bonds and long corp. bonds. During eco. slowdown, the credit spread widens, and the loss from the short treasury position creates a net loss, esp. if the bond issuers on the long side are also experiencing a financial difficulty.

Equity Market Risks- As mentioned earlier, even though market neutral funds have zero beta and low volatility, they are affected by the market movements. Long/short equity funds have higher standard deviations and higher correlation compared to either market neutral or risk arbitrage funds.

Emerging market funds actually have a low beta in a bullish market and a high beta in a bearish market. So, they don’t fully participate in a high market and suffer great losses in a down market.

Style drift and Leverage- Managers often take on addl. leverage and drift from their style to take advantage of market movements. However, over the long term, this is not a good tactic because they might lack expertise in the area of the new style.

Fraud Risk:

This represents misrepresentation of background qualifications, assets under management etc. by the manager. If the returns are too go to be true, then they probably are.

Operational Risk:

Arises from deficiency in procedures, infrastructure, resources, supervision or trade data.

There are some other types or risks such as counterparty risk, transaction risk and settlement risk.

Measuring Hedge Fund Risk

There are two methods that can be used=

Maximum Drawdown- Is the % decrease in investment value from its peak to its valley. It is the largest drawdown that has ever occurred within a specific time frame. However, it doesn’t give us the probability of the drawdown.

Value at Risk– Not only does it given an estimate of left tail risk , but also the probability. for example- there is a 99% (3 standard deviation minus) chance that the loss will not be more than 12% of its value over the next quarter.

Limitations of using VaR-

1. Generally uses historical data, which might not be repeated in the future.
2. Uses a normal distribution , whereas hedge fund returns re not normally distributed.
3. Computed assuming that the components are additive, whereas they are multiplicative in real life!

Some other methods:

Loss standard deviation- similar to standard deviation, but focuses on the left tail return.

Downside standard deviation- Measures left tail risk, but gives an acceptable threshold of return.

Sortini Ratio= Somewhat like Sharpe ratio, but it uses the downside deviation instead of standard deviation and the minium acceptable return in place of the risk free rate.

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Tags: HedgeFunds, Equity Valuation, CFA, Finance, Business

Reading 53: Evaluation of the Performance of your Hedge Funds

1. There are generally four types of hedge funds: Long/short funds, Global Macro Funds, Event Driven funds and market neutral funds.

2. Two methods of evaluation performance:

Jensen’s Alpha (ex post alpha): E(R)= Rf+ Beta (Market Risk Premium). Positive alpha means the port. is undervalued and a negative alpha means the port. is over-valued.

The Sharpe Ratio: (Ra-Rf)/Standard Deviation

3. It is difficult to compare a hedge fund to a benchmark due to the following reasons-

• Changes in Leverage- Even though a Fixed income arbitrage hedge fund might use leverage as high as 20 times its capital base, the benchmark index that is used is not multiplied twenty times.

• Changes in Hedging Techniques- Even though a market neutral fund has very low volatility because of the long and short positions that it takes, it is affect by the change in the market index. It maintains its short position either by short selling stock or by purchasing put options and paying the put premium. In case of a down market, short selling is more advantageous, even though the put option caps the loss at the premium paid, because short selling is much better than a deep out-of-money put option.

• Style Drift- Managers of hedge funds can always change their styles to take advantage of mispricing. In such a case, the original benchmark might no longer be appropriate.

• Portfolio Turnover- Managers might increase the turnover to exploit the volatility in the market and they might stray from their stated strategy. The return earned in such a case might be pure luck…you never know.

4. Evaluating a hedge fund’s performance: There are 3 different benchmarks that can be used: Broad Market Indexes, Hedge Fund Indexes and Risk free return.

Broad Market Index:

Both the Sharpe Ratio and the Jensen’s alpha method pose problems because they use S&P 500 for the evaluation of the performance, which might not be appropriate for evaluating fixed income arbitrage hedge funds. Second, the hedge fund’s beta can change depending upon the change in strategy. Third, alpha changes depending upon the time interval.

It has been found that Merrill Lynch High Yield Index is a good benchmark for fixed income arbitrage funds and Russell 3000 is a good benchmark for various equity funds like long/short equity, market neutral funds, global macro funds or emerging market funds.

Hedge Fund Index:

Different hedge funds have diff. strategies and are difficult to compare. This type of benchmark suffers from data and questionable statistics problem:

Data Problems:

• Voluntary report of performance of hedge funds means that many times, hedge funds with poor performance don’t submit their reports
• The returns of some large hedge funds might be excluded
• self-reported hedge fund data is not confirmed by index providers.

Questionable stats problems:

• Constituent funds change over time, so the index is inconsistent
• funds are subjected to survivorship and backfill bias
• some hedge funds are closed to new investors
• serial correlation in hedge funds lead to low standard deviation
• the historical record of hedge funds is very limited.

Risk Free Rate Method: Many managers feel that if a premium is added to the risk free rate, then it should give a nice assessment for the management and marketing fees and will make for a nice benchmark.

Of the equity funds, market neutral fund has a return that is closest to the risk free rate. Even though these funds are supposed to have zero beta, it is not always so, because if they are neutral on the basis of dollars, then the beta will not be zero. Hence, some risk is always there. Besides, it might also have some unsystematic risk.

On the fixed income side, the arbitrage funds take long positions on corporate bonds and a short position on the treasury bonds and seek to exploit the credit spread. In case of the crisis, if the yield on the corp. bond rises ( price decreases) and the yield on treasury bond falls (price increases) , then they will suffer huge losses. Besides, they also use a very high leverage. So risk free rate is not a good benchmark.

Conclusion: Never use any one benchmark in isolation, instead mix and match all of them. It is necessary to keep in mind the investor’s investment objective, the style, risk and leverage. For equity funds- we should should a weighted average beta to conclude the required return. For fixed income funds, we should multiply the credit spread by the leverage used. In either cases, a benchmark based on several factors may be used.

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Tags: HedgeFunds, Equity Vauation, CFA, Finance, Business, Thoughts

Reading 46: Dividend Discount Valuation

I have been reading this chapter since yesterday and I’ve made some good progress with the material here- mainly due to the fact that most of it is not new to me. We have been re introduced to concepts such as DDM, Gordon Growth Model (GGM) etc.

The Curriculum has a very nice summary at the end. So, I don’t think I’ll be putting up any notes for this reading. It will be a waste of time for me. I have another eight pages left to read. Also, the chapter end problems.

I’ll post some formulae tomorrow. That’s all.

I need to complete Equity Valuation by 12/31. That’s another 250 pages to read. As of now, it sounds a little daunting, but I think I should be able to manage it, provided I don’t get drunk and waste time. Moreover, I need to remind myself to study.

Reading 43: Valuation in Emerging Markets

After about 4 days, I finally picked up my book again. Blame it on my Graduation excitement. Yeah- I’m an MBA now. 🙂

I did this reading from Schweser after seeing that the official reading is too long. I might come back to the official curriculum in case I’m having trouble solving questions. I worked out the concept checkers at the end of Schweser material and they are really good.

Main Concepts:

1. The real valuation approach discounts real cash flows at the real rate of return, while the nominal valuation approach discounts nominal cash flows at the nominal rate of return. But the value of the firm using both the methods will be almost the same.

2. Cash flow forecasting for real markets tends to be challenging because of the high inflationary environment. Three issues require particular attention-

• Income taxes are based on nominal earnings; so an estimation of nominal EBITA is required.
• Real NWC and Nominal NWC are not the same. We need to divide Nominal NWC by the inflation rate to arrive at the Real NWC. The change in the nominal NWC captures the flow effect, but the holding loss in real NWC is ignored. So, in an inflationary environment, the investment in Real NWC increases and the real FCF decreases.
• Nominal capital expenditures are difficult to calculate by simply calculating sales and related expenditures because of the high inflation. So, we need to calculate the real sales, real capital expenditures, real EBITDA and depreciation on a real basis.

3. FCF= NOPLAT+ Depreciation- Change in NWC- Change in Net Capital Expenditure

NOPLAT= EBITA- Taxes

4. Steps for valuing a firm in an emerging economy on a real and nominal basis are-

• Calculate the revenue, EBITDA, Invested Capital and EBITA on a real basis.

[Note: Invested Capital= Net PPE (End)+ NWC;

Net PPE (End)= Net PPE (Beg)- Depreciation +Capital Expenditure.

Depreciation is calculated by Dividing the Beg. PPE by the number of years.]

• Calculate the Revenue, EBITDA, Depreciation and EBITA on a nominal basis.
• Calculate the real NOPLAT
• Calculate FCF on a real and nominal basis.
• Estimate firm value in both real and nominal terms by discounting the real and nominal FCF at the real WACC and the nominal WACC. The nominal WACC is not the same every year because of the inflation rate. (1+nominal rate)= (1+real rate)(1+ inflation rate)

Effect on Financial Ratios: Generally the ratios in real terms are accurate and the ratios in nominal terms are incorrectly estimated. ROIC (Return on Investment Capital= NOPLAT/Beg. Invested Capital) is overstated in nominal terms. NWC/Revenue is correctly states in both real and nominal terms. Ratio of PPE/Revenue is generally understated in nominal terms.

5. There are two ways of incorporating emerging market risk in the valuation process- a. Adjusting the cash flows in a scenario basis b. Adjusting the discount rate by adding a country risk premium. Adjusting the cash flows has more support because of the following reasons-

• Country risks are diversiable
• Companies respond differently to country risk. (All companies might not use the same country risk premium. So it’s better to adjust the individual cash flows).
• There is no systematic method to calculate a country risk premium.
• When managers have to discuss emerging market risks and their effects on cash flow in scenarios, they gain more insights than they would get from country risk premium.

6. Calculation of WACC should follow these guidelines-

Risk free rate= 10 yr US Govt Bond Yield + Difference in inflation betn. both the countries

Beta= Industry beta from a globally diversified market index.

Market Risk Premium should be between 4.5-5.5% (long term average risk premium on a global market index)

Pre-tax cost of debt= Local Risk free rate + US credit spread on comparable debt

Marginal Tax Rate- Only taxes that apply to the interest expense should be included. Other taxes or credits should be modeled directly in the cash flows.

Some assumptions that are used while calculating WACC-

We have adopted the perspective of an international investor who has a diversified portfolio. As long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Another assumption is that most country risks are diversifiable from the perspective of a global investor. We therefore need no addl. risk premium in the cost of capital when discounting cash flows.

7. When using the Country Risk Premium approach, we should keep the following points in mind-

Do not simply use the sovereign risk premium which is the difference betn. the long term US bond yield and a dollar denominated local bond’s yield with the same maturity. This is because this difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued moves closely in line with the payments on government bonds.

We need to understand estimates from different analyst sources because the underlying assumptions will vary. For eg- A high country risk premium might be used along with a very high growth rate and a low country risk premium might be used with a low growth rate. So the final value might still be the same.

We should not set the country risk premium too high. One way to do this is to compare the expected return using the CAPM Model with the historical real rate of return.

Reading 42: Industry Analysis

This reading was quite interesting. I used Schweser as a study guide to get a gist of the entire chapter and then used the Curriculum for my main reading. Took me about 2.5 hours, I guess. I worked out the concept checkers at the end of Schweser 2007.

Main points:

The model of an Industry Analysis should include-

Industry Classification

External Factors

Demand analysis

Supply Analysis

Profitability

International Competition and Markets (Not covered by the LOS).

Let’s discuss each of these parts in details now-

I. Industry Classification– Can be done either by Industry Life Cycle or Business Life Cycle.

a. Industry Life Cycle– Pioneer, Growth, Mature and Decline are the 4 stages.

Pioneer- 7/10 start up businesses fail to survive.

Growth- Even when the economy is doing poorly, growth industries can experience positive profits. They prosper independent of the business cycle.

Mature- Within a mature industry, there might be a couple of growth companies. They can achieve this by acquisition or improved quality/service.

Decline- Remaining participants consolidate. The better managed survivors anticipate this fate and avoid it by using cash flow to diversify into promising industries.

b. Business Life Cycle– Industry classified as either-

Growth -above normal rate of expansion and independent of the business cycle. Eg- Computer Software Industry).

Defensive- Stable performance throughout the business cycle. Egs- Utilities, food, cigarettes and beer industry and govt. contractors.

Cyclical- Produce discretionary products, the consumption of which depends upon the economic optimism. Egs- Auto industry, heavy equipment and machine tool producers. Certain cyclical firms experience earnings patterns that do not correlate well against the general economy, but trend against other economic variables. (Brokerage firms use the stock prices as their base and agricultural firms that are related to the crop price cycle).

Problems with Industry Classification-

a. Self-deception- placing all not all companies in a mature industry are mature companies.

II. External Factors-

There are five external factors:

Technology- For pioneer industries, the question is will the market accept the innovation? For mature industries, the question is- will the industry face obsolescence from competing technologies?

Govt- New regulations, changes etc. can impact an industry either positively or negatively. For eg- Tobacco industry facing problems.

Social changes- Either due to fashion or lifestyle changes. Fashion changes are of a shorter duration and more unpredictable. Eg- women’s clothing line. Lifestyle changes take place over long periods of time and easier to determine.

Demographics- Studying the vital stats of population, such as distribution, age and income. They are easier to identify and track compared to other external factors, but disagreement occures in sizing up its impact on relevant industries.

Foreign influences-Foreign policies and restrictions.

III. Demand Analysis- Can be achieved in three ways-

a. Top Down Economic Analysis when the revenues correlate strongly to one economic statistic.

b. Industry Life cycle- Categorizing the industry within its life cycle position.

c. External Factors

Customer Study- Segmenting the customers into submarkets (based on user type, type of business, geographic, sex, age etc.) to study a smaller number of factors that contribute to demand.

For established industries, the analyst should contact long time customers to figure what drives demand in each submarket.

For growth industries- the analyst considers new outlets for the industry’s products.

Untested industries- We need to determine if the new industry fulfills a need that exists and isn’t being met by another industry. Assuming a new is verified, analysts typically forecast new industry sales based on the experience of a similar industry.

Input/Output Analysis- A rising consumption of the finished product boosts demand for industries supplying the intermediate steps.

IV. Supply Analysis-

In the long term, it is appreopriate to assume that supply will equal demand. In the short term, there can be a shortfall in supply in case of –

a. Capacity intensive industries where the lead time is high, or

b. When capacity is diabled due to natural disasters.

The analyst should obtain data on the aggregate size of the potential supply of output from a given industry- incl. foreign industry- and compare this with projected demand for the industry output (called capital utilization data, which is equal to the total capacity divided by the total demand).

V. Profitability, Pricing and the Industry Study

A supply/demand forecast gives an indication of future profitability. A projected oversupply will retard investment since it augurs lower prices.

Factors contributing to pricing include:

a. Product segmentation- Most industries effectively segment their product offerings by brand name, reputation, or service, even when the products are quite similar.

b. Degree of industry concentration

c. Ease of industry entry

d. Price changes in key supply inputs

****

I left out the pages that talked about International Competition and Markets because it’s not covered by any of the relevant LOSs.