on 18-Mar-2016 (Fri)

• Restrictions on debt regulate the issue of additional debt. Maximum acceptable debt usage ratios (sometimes called leverage ratios or gearing ratios) and minimum acceptable interest coverage ratios are frequently specified, permitting new debt to be issued only when justified by the issuer’s financial condition.

• Negative pledges prevent the issuance of debt that would be senior to or rank in priority ahead of the existing bondholders’ debt.

• Restrictions on prior claims protect unsecured bondholders by preventing the issuer from using assets that are not collateralized (called unencumbered assets) to become collateralized.

• Restrictions on distributions to shareholders restrict dividends and other payments to shareholders such as share buy-backs (repurchases). The restriction typically operates by reference to the borrower’s profitability; that is, the covenant sets a base date, usually at or near the time of the issue, and permits dividends and share buy-backs only to the extent of a set percentage of earnings or cumulative earnings after that date.

• Restrictions on asset disposals set a limit on the amount of assets that can be disposed by the issuer during the bond’s life. The limit on cumulative disposals is typically set as a percentage of a company’s gross assets. The usual intent is to protect bondholder claims by preventing a break-up of the company.

• Restrictions on investments constrain risky investments by blocking speculative investments. The issuer is essentially forced to devote its capital to its going-concern business. A companion covenant may require the issuer to stay in its present line of business.

• Restrictions on mergers and acquisitions prevent these actions unless the company is the surviving company or unless the acquirer delivers a supplemental indenture to the trustee expressly assuming the old bonds and terms of the old indenture. These requirements effectively prevent a company from avoiding its obligations to bondholders by selling out to another company.

The role of financial reporting is to provide information about a company's financial position and performance for use by parties both internal and external to the company. Financial statements are issued by management, who is responsible for their form and content.

The role of financial statement analysis, on the other hand, is to take these financial statements and other information to evaluate the company's past, current, and prospective financial position and performance for the purpose of making rational investment, credit, and similar decisions.

The primary users of financial statements are equity investors and creditors.

• Equity investors are primarily interested in the company's long-term earning power, growth, and ability to pay dividends.
• Short-term creditors (e.g., banks and trade creditors) are more interested in the company's immediate liquidity, because they seek an early payback of their investment.
• Long-term creditors (e.g., corporate bond owners such as insurance companies and pension funds) are primarily concerned with the company's long-term asset position and earning power.

Financial statements are the most important outcome of the accounting system. They communicate financial information gathered and processed in the company's accounting system to parties outside the business.

The four principal financial statements are:

• Income statement (statement of earnings)
• Balance sheet (statement of financial position)
• Cash flow statement
• Statement of changes in owners' or stockholders' equity

These four financial statements, augmented by footnotes and supplementary data, are interrelated. In addition, there are other sources of financial information, such as management discussion and analysis, auditor's reports, etc.

Income Statement

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies. The following is a generic sample:

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings. As operating expenses do not include financing costs such as interest expenses, income from continuing operations is independent of the company's capital structure.

In the typical income statement this means segregating the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.

Balance Sheet

A balance sheet provides a "snapshot" of a company's financial condition. Think of the balance sheet as a photo of the business at a specific point in time. It reports major classes and amounts of assets, liabilities, stockholders' equity, and their interrelationships as of a specific date.

Assets = Liabilities + Stockholders' Equity

• Assets are the economic resources controlled by the company.
• Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
• Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

Cash Flow Statement

The primary purpose of the cash flow statement is to provide information about a company's cash receipts and cash payments during a period. It reports the cash receipts and cash outflows classified according to operating, investment, and financing activities.

The cash flow statement is useful because it provides answers to the following simple yet important questions:

• Where did the cash come from during the period?
• What was the cash used for during the period?
• What was the change in the cash balance during the period?

The statement's value is that it helps users evaluate liquidity, solvency, and financial flexibility.

• Liquidity refers to the "nearness to cash" of assets and liabilities, or having enough cash available to pay debts when they are due.
• Solvency refers to the company's ability to pay its debts as they mature. Cash flows reflect the company's liquidity and long-term solvency.
• Financial flexibility refers to a company's ability to respond and adapt to financial adversity and unexpected needs and opportunities. For example, cash flow information can be used to evaluate the effects of major investment and financing decisions.

Statement of Changes in Owners' Equity

This statement reports the amounts and sources of changes in equity from capital transactions with owners. It reports ownership interests in order of preference upon liquidation and dividends. For example, the first item listed gets paid off first after creditors in the event of liquidation.

Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Other Sources of Information

• Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

• Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

• Companies' websites, press releases, and conference calls.

The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
• Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

• An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
• A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
• An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

• A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on Internal Controls

Following the enactment of the Sarbanes-Oxley Act of 2002, the Public Company Accounting Oversight Board (PCAOB) was established in order to monitor, regulate, inspect, and discipline audit and public accounting firms of public companies. The PCAOB Auditing Standards No. 2 now requires auditors of public companies to include an additional disclosure in the opinion report regarding the auditee's internal controls, and to opine about the company's and auditor's assessment of the company's internal controls over financial reporting. These new requirements are commonly referred to as the COSO Opinion.

he financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

• Articulate the purpose and context of the analysis.
  What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?
  The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

• Collect input data.
  Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

• Process data.
  Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

• Analyze / interpret the processed data.
  Interpret the output to support a conclusion (e.g., a buy decision).

• Develop and communicate conclusions and recommendations.
  Communicate the conclusion or recommendation in an appropriate format.

• Follow up.
  Periodic review is required to determine if the original conclusions and recommendations are still valid.

PREVIOUS LOS

Business activities can be classified into three groups:

• Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:
  • Selling goods and services
  • Employing managers and workers
  • Buying goods and services
  • Paying taxes

• Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:
  • Buying resources such as land, buildings, and equipment needed in the operation of the business.
  • Selling these resources when no longer needed.
  Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

• Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:
  • Issuing stock
  • Paying dividends to stockholders
  • Obtaining loans from creditors
  • Repaying amounts plus interest to creditors
  Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

An account is a label used for recording and reporting a quantity of almost anything. It is the:

• Means by which management keeps track of the effects of transactions.
• Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

• An asset is usually listed on the balance sheet.
• It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

• Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
• Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
• Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
• Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

• Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
• Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

• Contributed capital is the amount invested in the business by the owners.
• Retained earnings are the company's undistributed earnings: accumulated earnings since inception less any losses, dividends, or transfers to contributed capital.

Revenue

Income (often referred to as "revenue") for a company is generated by delivering or producing goods, rendering services, or other activities that constitute the company's ongoing major or central operations. Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

Expenses

Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute an entity's ongoing major or central operations. An expense represents an event in which an asset is used up or a liability is incurred. Not all cash payments are expenses; for example, cash dividends paid to stockholders are not expenses.

Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

• Dividends and expenses decrease owners' equity.
• Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
A = $50,000							L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
2	-35,000			$10,000	$25,000			$50,000
bal	$15,000			$10,000	$25,000			$50,000
A = $50,000							L + OE = $50,000
This transaction only affects one side of the accounting equation: assets. Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land

...

Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

• A balance sheet must list all assets and liabilities at the end of the accounting period.
• An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

• Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

• Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

• Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

• Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

• If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
• If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other comprehensive income.

Here are financial statements based on previous transactions for ABC Realty.

It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.

Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies.

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings.

As operating expenses do not include financing costs such as interest expenses, income from continuing operations is independent of the company's capital structure.

In the typical income statement analyisis one should segregate the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.

Financial Footnotes provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc.

Financial Footnotes are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Financial footnotes are an integral part of financial statements.

PORTFOLIO MANAGEMENT

Why should investors take a portfolio approach instead of investing in individual stocks? Why not put all your eggs in one basket?

Portfolio theory is used to maximize an investment's expected rate of return for a given level of risk, or minimize the level of risk for a given expected rate of return.

For the purpose of investing, risk is defined as the variation of the return from what was expected (volatility). It is represented by a measure such as standard deviation.

Diversification is used to reduce a portfolio's overall volatility. By building a portfolio out of many unrelated (uncorrelated) investments total volatility (risk) is minimized. The idea is that most assets will provide a return similar to their expected return and will offset those in the portfolio that perform poorly. The diversification ratio is the ratio of the standard deviation of an equally weighted portfolio to the standard deviation of a randomly selected security.

• The composition of a portfolio matters a great deal. Different portfolios have different risk-return trade-offs.
• Portfolio diversification does not necessarily provide the same level of risk reduction during times of severe market turmoil as it does when the economy and markets are operating normally.
• The modern portfolio theory says that the value of an additional security to a portfolio ought to be measured with its relationship to all of the other securities in the portfolio.

There are different types of investment clients.

Different individual investors have different investment goals, risk tolerance and constraints. Some seek growth while others may invest to get regular income.

An institutional investor's role is to act as highly specialized investors on behalf of others. There are many types of institutional investors.

A pension plan is a fund that provides retirement income to employees. It is typically considered a long-term investor which has high risk tolerance and low liquidity needs.

• In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. Only the employer's contribution is defined; no promise is made regarding the ultimate benefits paid out to the employee. The employee accepts the investment risk.
• A defined benefit plan defines the benefits that the employee will receive at the time of retirement. That is, the employer assumes the risk of the investment, and is responsible for the payment of the defined benefits without regard to what happens in the trust.

An endowment or a foundation is an investment fund set up by an institution in which regular withdrawals from the invested capital are used for ongoing operations. Endowments and foundations are often used by universities, hospitals and churches. They are funded by donations. A typical investment object is to maintain the real value of the fund while generating income to fund the objectives of the institution.

A bank typically has very short investment horizon and low risk tolerance. Its investments are usually conservative. The investment objective of a bank's excess reserves is to earn a return that is higher than the interest rate it pays on its deposit.

Investments made by insurance companies are relatively conservative. Although the income needs are typically low, the liquidity needs of such investments are usually high in order for insurance companies to pay claims.

Both the risk tolerance and the return requirement of mutual funds are predefined for each fund and can vary sharply between funds. They are more specialized than pension funds or insurance companies. Study Session 18 discusses mutual funds in more detail.

A sovereign wealth fund is a state-owned investment fund. There are two types of funds: saving funds and stabilization funds. Stabilization funds are created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy.

Step One: The Planning Step

The first step in the portfolio management process is to understand the client's needs and develop an investment policy statement (IPS).

The IPS covers the types of risks the investor is willing to assume along with the investment goals and constraints. It should focus on the investor's short-term and long-term needs, familiarity with capital market history, and investor expectations and constraints. Periodically the investor will need to review, update and change the policy statement.

A policy statement is like a road map: It forces investors to understand their own needs and constraints and to articulate them within the construct of realistic goals. It not only helps investors understand the risks and costs of investing, but also guides the actions of portfolio managers.

Step Two: The Execution Step

The second step is to construct the portfolio. The portfolio manager and the investor determine how to allocate available funds across different countries, asset classes, and securities. This involves constructing a portfolio that will minimize the investor's risk while meeting the needs specified in the policy statement.

Step Three: The Feedback Step

The process of managing an investment portfolio never stops. Once the funds are initially invested according to the plan, the real work begins in monitoring and updating the status of the portfolio and the investor's needs.

The last step is the continual monitoring of the investor's needs, capital market conditions, and, when necessary, updating the policy statement. One component of the monitoring process is to evaluate a portfolio's performance and compare the relative results to the expectations and the requirements listed in the policy statement. Some rebalancing may be required.

"Pooled investments" is a term given to a wide range of investment types, such as mutual funds, exchange traded funds, separately managed accounts. When you invest in a pooled investment, your money goes into an investment fund. Here, you pool your money with others so you can help spread the risk. Professional fund managers then invest the money on your behalf in a highly competitive environment.

Mutual Funds

An investment company invests a pool of funds belonging to many individuals in a single portfolio of securities. In exchange for this commitment of capital, the investment company issues to each investor new shares representing his or her proportional ownership of the mutually held securities portfolio, which is commonly known as a mutual fund.

Mutual funds are classified according to whether or not they stand ready to redeem investor shares.

• An open-end mutual fund continues to sell and repurchase shares after its initial public offering. It stands ready to redeem investor shares at market value.
• A closed-end mutual fund operates like any other public firm. It is initiated through a stock offering to raise capital. Its stock trades on the regular secondary market and the market price is determined by supply and demand. A typical closed-end fund offers no further shares and does not repurchases the shares on demand (no funds can be withdrawn). Therefore, investors must trade in public secondary markets (e.g. NASDAQ) to buy or sell shares.

Various fees charged by mutual funds:

• They charge fees for their efforts of setting up funds. Sales commissions are charged at purchase (front-end load) as a percentage of the investment.
  • A load fund has sales commission charges. A load fund's offering price = NAV of the share + a sales charge (7.5 - 8% of the NAV). The NAV price is the redemption (bid) price, and the offering (ask) price equals the NAV divided by 1 minus the percent load.
  • A no-load fund imposes no initial sales charge.

• Redemption fee (back-end load). A charge to exit the fund. This discourages quick trading turnover and are set up so that the fees decline the longer the shares are held (in this case, the fees are sometimes called contingent deferred sales charges). Load funds generally charge no redemption fees.
• All mutual funds charge annual fees.

There are four types of mutual funds based on portfolio makeup.

• Money Market Funds. These funds attempt to provide current income, safety of principal, and liquidity by investing in diversified portfolios of short-term securities, such as T-bills, banker certificates of deposit, bank acceptances, and commercial paper. They generally allow holders to write checks again their account so they are essentially cash holdings for holders. However, they are not insured in the same way as bank deposits.
• Bond Mutual Funds. Bond funds concentrate on various types of bonds to generate high current income with minimal risk. Bonds held include government bonds, high-grade corporate bonds, and junk bonds.
• Stock Mutual Funds. These funds invest almost solely in common stocks. Some funds focus on growth companies while others specialize in specific industries. Different stock mutual funds can suit almost any taste or investment objective.
  There are two investment styles.
  • Passive mutual fund management is a long-term buy-and-hold strategy. Usually stocks are purchased so the portfolio's returns will track those of an index over time. The purpose is not to beat the index but to match its performance.
  • An active mutual fund management is an attempt by the fund manager to outperform a passive benchmark portfolio on a risk-adjusted basis. The management fees are usually higher and there are usually more trading activities which can cause tax consequences for investors.

• Hybrid/Balanced Funds. They diversify outside the stock market by combining common stock with fixed-income securities.

Other Investment Products

2. Separately Managed Accounts

The key difference between mutual funds and separate accounts is that, in a separate account, the money manager is purchasing the securities in the portfolio on behalf on the investor, not on behalf of the fund. Therefore, the investor can determine which assets are bought or sold, and when.

A mutual fund investor owns shares of a company (mutual fund) that in turn owns other investments, whereas an SMA investor owns the invested assets directly in his own name.

An investor in an SMA typically has the ability to direct the investment manager to sell individual securities with the objective of raising capital gains or losses for tax planning purposes. This practice is known as "tax harvesting", and its objective is to attempt to equalize capital gains and losses across all of the investor's accounts for a given year in order to reduce capital gains taxes owed.

Another major advantage of individual cost basis is the ability to customize the portfolio by choosing to avoid investing in certain stocks or certain economic sectors (technology, sin stocks, etc).

3. Hedge Funds

A hedge fund is an investment fund open to a limited range of investors that undertakes a wider range of investment and trading activities than traditional long-only investment funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund has its own investment strategy that determines the type of investments and the methods of investment it undertakes.

Unlike mutual funds, most hedge funds are not regulated. The net effect is that hedge fund investor base is generally very different from that of the typical mutual fund.

Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used. A hedge fund will typically commit itself to a particular strategy, particular investment types and leverage limits via statements in its offering documentation, thereby giving investors some indication of the nature of the particular fund.

4. Buyout and Venture Capital Funds

Both funds take equity positions and plan a very active role in the management of the company. The equity they hold is private, and they don't have long investment horizon.

• Buyout funds make only a few large investments in public companies with the intent of selling the restructured companies in three to five years.
• Venture capital funds buys start-up companies and grow them. They play a very active role in managing these companies.

Risk is exposure to uncertainty. In investment, risk includes the possibility of losses.

Taking risks is an active choice by institutions and individuals. Risks must be carefully understood, chosen, and well-managed.

Risk exposure is the extent to which an entity's value may be affected through sensitivity to underlying risks.

Risk management is a process that defines risk tolerance and measures, monitors, and modifies risks to put them in line with that tolerance.

• It is NOT about minimizing, avoiding or predicting risks.
• It is about understanding, measuring, monitoring, and modifying risks.

A risk management framework is the infrastructure, processes, and analytics needed to support effective risk management. It includes:

• Risk governance is the top-level foundation for risk management. It provides the overall context for an organization's risk management, which includes risk oversight and setting risk tolerance for the organization. It directs risk management activities to align with and support the goals of the overall enterprise.

• Risk identification and measurement is the quantitative and qualitative assessment of all potential sources of risk and risk exposures.

• Risk infrastructure comprises the resources and systems required to track and assess an organization's risk profile.

• Risk policies and processes are management's complement to risk governance at the operating level.

• Risk monitoring, mitigation and management is the active monitoring and adjusting of risk exposures, integrating all the other factors of the risk management framework.

• Communication includes risk reporting and active feedback loops so that the process improves decision making.

• Strategic risk analysis and integration involves using these risk tools to rigorously sort out the factors that are and are not adding value as well as incorporating this analysis into the management decision-making process, with the intent of improving outcomes.

Governance and the entire risk process should take an enterprise risk management perspective to ensure that the value of the entire enterprise is maximized. For example, a corporate pension fund manager should consider not only the pension assets and liabilities but also the parent corporation's business risk profile. In other words, the focus should be on the organization as a whole.

Useful approaches to ensuring a strong risk governance framework:

• Employ a risk management committee.
• Appoint a chief risk officer.

Risk Tolerance

Risk tolerance, a key element of good risk governance, establishes an organization's risk appetite.

Ascertaining risk tolerance starts from an inside view and an outside view. What shortfalls within an organization would cause the organization to fail to achieve some critical goals? What are the organization's risk drivers? Which risks are acceptable and which are unacceptable? How much risk can the overall organization be exposed to?

Risk tolerance is then formally chosen using a top-level analysis. The organization's goals, expertise in certain areas, and strategies should be considered when determining its risk tolerance. This process should be completed and communicated before a crisis.

Risk Budgeting

While risk tolerance determines which risks are acceptable, risk budgeting decides how to take risks. It is a means of implementing risk tolerance at a strategic level.

Risk budgeting is any means of allocating investments or assets based on their risk characteristics. Single or multiple dimensions of risk can be used. Common single-dimension risk measures are standard deviation, beta, value at risk, and scenario loss. The risk budgeting process forces the firm to consider risk trade-offs. As a result, the firm should choose to invest where the return per unit of risk is the highest.

Some risk budgeting practices:

• Limit the standard deviation of the entire portfolio to within 15%.
• Allocate 10%, 35% and 55% of total capital in T-bills, long-term corporate bonds, and stock market index-linked mutual funds, respectively.
• Use a risk factor approach to allocate assets.

There are two general categorizations of risks.

Financial Risks

Financial risks originate from the financial markets.

• Market risk arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
• Credit risk is the risk that a counterparty will not pay an amount owed.
• Liquidity risk is the widening of the bid-ask spread on an asset. It is usually caused by degradation in market conditions or a lack of market participants.

Non-Financial Risks

Non-financial risks arise from actions within an entity or from external origins, such as the environment, the community, regulators, politicians, suppliers, and customers. They include:

• Settlement risk: one party fails to deliver the terms of a contract with another party at the time of settlement.
• Legal risk: the risk of being sued, or of the terms of a contract not being upheld by the legal system.
• Compliance risk: regulatory risk, accounting risk and tax risk. Companies may fail to respond quickly when laws and regulations are updated.
• Model risk: the risk of improperly using a model. An example is tail risk which suggests that distribution is not normal, but skewed, with fatter tails.
• Operational risk: the risk that arises from within the operations of an organization and includes both human and system or process errors.
• Solvency risk: the risk that the entity does not survive or succeed because it runs out of cash to meet its financial obligations.

Individuals face many of the same organizational risks outlined here, as well as health risks, mortality or longevity risks, and property and casualty risks.

Risks are not necessarily independent. because many risks arise as a result of other risks; risk interactions can be extremely non-linear and harmful. For example, fluctuations in the interest rate cause changes in the value of the derivative transactions but could also impact the creditworthiness of the counterparty. Another example might occur with an emerging-market counterparty, where there is country and possibly currency risk associated with the counterparty (however creditworthy it might otherwise be).

Learning Outcome Statements

g. describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods.


Drivers

To understand how to measure risk, we need to first understand what drives risk. Risk drivers are the fundamental global and domestic macroeconomic and industry factors that create risk.

• All risks come from uncertainties.
• Financial risks come from fundamental factors in macro-economies and industries.
• There are systematic risks and unsystematic (diversifiable) risks.

Risk management can control some risks but not all.

Metrics

Common measures of risk:

• Probability
• Standard deviation: measures dispersion in a probability distribution. This has significant limitations.
• Beta: measures the sensitivity of a security's returns to the returns on the market portfolio.
• Measures of derivatives risk: delta, gamma, vega and rho.
• Duration measures the interest rate sensitivity of a fixed income security.
• Value at Risk: measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. If the VaR on an asset is $100 million at a one-week, 95% confidence level, there is only a 5% chance that the value of the asset will drop more than $ 100 million over any given week.
• CVaR: scenario analysis and stress testing, can be used to complement VaR.

It is difficult to measure rare events such as operational risk and default risk.

Methods of Risk Modification

There are four broad categories of risk modification.

Risk prevention and avoidance. Completely avoiding risk sounds simple, but it may be difficult or sometimes impossible. Furthermore, does it even make sense to do so? Almost every risk has an upside. There is always a trade-off between risk and return.

Risk acceptance. Risk can be mitigated internally through self-insurance or diversification. This is to bear the risk but do so in the most efficient manner possible.

Risk transfer. This is to pass on a risk to another party, often in the form of an insurance policy. An insurer attempts to sell policies with risks that have low correlations and can be diversified away.

Risk shifting. This refers to actions that change the distribution of risk outcomes. The principal device is a derivative which can be used to shift risk across the probability distribution and from one party to another. There are two categories of derivatives: forward commitments and contingent claims.

The primary determinant of which method is best for modifying risk is weighing the benefits against the costs, with consideration for the overall final risk profile and adherence to risk governance objectives.

The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable

The auditor examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An asset is usually listed on the balance sheet.

Not all cash receipts are revenues; for example, cash received through a loan is not revenue.

Income or "revenue" is generated the company's major or central operations

Revenue - Expenses = Net income (loss)

Ending retained earnings = Beginning retained earnings + Net income - Dividends

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

Liquidity refers to the "nearness to cash" of assets and liabilities, or having enough cash available to pay debts when they are due.

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.

Intangible assets include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs.

a. calculate and interpret the net present value (NPV) and the internal rate of return (IRR) of an investment;

b. contrast the NPV rule to the IRR rule, and identify problems associated with the IRR rule;


A company should choose those capital investment processes that maximize shareholder wealth.

The net present value (NPV) of an investment is the present value of its cash inflows minus the present value of its cash outflows. The internal rate of return (IRR) is the discount rate that makes net present value equal to 0.

According to the NPV rule, a company should accept projects where the NPV is positive and reject those in which the NPV is negative. A positive NPV suggests that cash inflows outweigh cash outflows on a present value basis. That is, the positive cash flows are sufficient to repay the initial investment along with the capital costs (opportunity cost) associated with the project. If the company must choose between two, mutually-exclusive projects, the one with the higher NPV should be chosen.

• According to the IRR Rule, a company should accept projects where the IRR is greater than the discount rate used (WACC) and reject those in which the IRR is less than the discount rate. An IRR greater than the WACC suggests that the project will more than repay the capital costs (opportunity costs) incurred.
  
  There are three problems associated with IRR as a decision rule.

• Reinvestment
  The IRR is intended to provide a single number that represents the rate of return generated by a capital investment. As such, it is an easy number to interpret and understand. However, calculation of the IRR assumes that all project cash flows can be reinvested to earn a rate of return exactly equal to the IRR itself. In other words, a project with an IRR of 6% assumes that all cash flows can be reinvested to earn exactly 6%. If the cash flows are invested at a rate lower than 6%, the realized return will be less than the IRR. If the cash flows are invested at a rate higher than 6%, the realized return will be greater than the IRR.

• Scale
  In most cases, NPV and IRR rules provide the same recommendation as to whether to accept or reject a given capital investment project. However, when choosing between two mutually-exclusive projects (ranking), NPV and IRR rules may provide conflicting recommendations. In such cases, the NPV rule's recommendation should take precedence.
  One of the situations in which IRR is likely to contradict NPV is when there are two mutually-exclusive projects of greatly differing scale: one that requires a relatively small investment and returns relatively small cash flows, and another that requires a much larger investment and returns much larger cash flows.

• Timing
  The other situation in which IRR is likely to contradict NPV is when there are two mutually-exclusive projects whose cash flows are timed very differently: one that receives its largest cash flows early in the project and another that receives its largest cash flows late in the project.

The net present value (NPV) of an investment is the present value of its cash inflows minus the present value of its cash outflows. The internal rate of return (IRR) is the discount rate that makes net present value equal to 0.

Holding Period Return

When analyzing rates of return, our starting point is the total return, or holding period return (HPR). HPR measures the total return for holding an investment over a certain period of time, and can be calculated using the following formula:

• P_t = price per share at the end of time period t
• P_(t-1) = price per share at the end of time period t-1, the time period immediately preceding time period t
• P_t - P_t-1 = price appreciation of the investment
• D_t = cash distributions received during time period t: for common stock, cash distribution is the dividend; for bonds, cash distribution is the coupon payment.

It has two important characteristics:

• It has an element of time attached to it: monthly, quarterly or annual returns. HPR can be computed for any time period.
• It has no currency unit attached to it; the result holds regardless of the currency in which prices are denominated.

Example

A stock is currently worth $60. If you purchased the stock exactly one year ago for $50 and received a $2 dividend over the course of the year, what is your holding period return?

R_t = ($60 - $50 + $2)/$50 = 0.24 or 24%

The return for time period t is the capital gain (or loss) plus distributions divided by the beginning-of-period price (dividend yield). Note that for common stocks the distribution is the dividend; for bonds, the distribution is the coupon payment.

The holding period return for any asset can be calculated for any time period (day, week, month, or year) simply by changing the interpretation of the time interval.

Return can be expressed in decimals (0.05), fractions (5/100), or as a percent (5%). These are all equivalent.

Learning Outcome Statements

c. calculate and interpret a holding period return (total return);

Dollar-weighted and Time-weighted Rates of Return

The dollar-weighted rate of return is essentially the internal rate of return (IRR) on a portfolio. This approach considers the timing and amount of cash flows. It is affected by the timing of cash flows. If funds are added to a portfolio when the portfolio is performing well (poorly), the dollar-weighted rate of return will be inflated (depressed).

The time-weighted rate of return measures the compound growth rate of $1 initial investment over the measurement period. Time-weighted means that returns are averaged over time. This approach is not affected by the timing of cash flows; therefore, it is the preferred method of performance measurement.

Example

Jayson bought a share of IBM stock for $100 on December 31, 2000. On December 31, 2001, he bought another share for $150. On December 31, 2002, he sold both shares for $140 each. The stock paid a dividend of $10 per share at the end of each year.

To calculate the dollar-weighted rate of return, you need to determine the timing and amount of cash flows for each year, and then set the present value of net cash flows to be 0: - 100 - 140/(1 + r) + 300/(1 + r)² = 0. You can use the IRR function on a financial calculator to solve for r to get the dollar-weighted rate of return: r = 17%.

To calculate the time-weighted rate of return:

• Split the overall measurement period into equal sub-periods on the dates of cash flows. For the first year:
  • beginning price: $100
  • dividends: $10
  • ending price: $150
  For the second year:
  • beginning price: $300 (150 x 2)
  • dividends: $20 (10 x 2)
  • ending price: $280 (140 x 2)

• Calculate the holding period return (HPR) on the portfolio for each sub-period: HPR = (Dividends + Ending Price)/Beginning Price - 1. For the first year, HPR₁: (150 + 10)/100 - 1 = 0.60. For the second year, HPR₂: (280 + 20)/300 - 1 = 0.

• Calculate the time-weighted rate of return:
  • If the measurement period < 1 year, compound holding period returns to get an annualized rate of return for the year.
  • If the measurement period > 1 year, take the geometric mean of the annual returns.
    
    

    Learning Outcome Statements

    d. calculate and compare the money-weighted and time-weighted rates of return of a portfolio and evaluate the performance of portfolios based on these measures;

Money market instruments are low-risk, highly liquid debt instruments with a maturity of one year or less. There are two types of money market instruments: interest-bearing instruments (e.g., bank certificates of deposit), and pure discount instruments (e.g., U.S. Treasury bills).

Pure discount instruments such as T-bills are quoted differently than U.S. government bonds. They are quoted on abank discount basis rather than on a price basis:

• r_BD = the annualized yield on a bank discount basis
• D = the dollar discount, which is equal to the difference between the face value of the bill, F, and its purchase price, P
• t = the number of days remaining to maturity
• 360 = the bank convention of the number of days in a year.

Bank discount yield is not a meaningful measure of the return on investment because:

• It is based on the face value, not on the purchase price. Instead, return on investment should be measured based on cost of investment.
• It is annualized using a 360-day year, not a 365-day year.
• It annualizes with simple interest and ignores the effect of interest on interest (compound interest).

Holding period yield (HPY) is the return earned by an investor if the money market instrument is held until maturity:

• P₀ = the initial price of the instrument
• P₁ = the price received for the instrument at its maturity
• D₁ = the cash distribution paid by the instrument at its maturity (that is, interest).

Since a pure discount instrument (e.g., a T-bill) makes no interest payment, its HPY is (P₁ - P₀)/P₀.

Note that HPY is computed on the basis of purchase price, not face value. It is not an annualized yield.

The effective annual yield is the annualized HPY on the basis of a 365-day year. It incorporates the effect of compounding interest.

Money market yield (also known as CD equivalent yield) is the annualized HPY on the basis of a 360-day year using simple interest.

Example

An investor buys a $1,000 face-value T-bill due in 60 days at a price of $990.

• Bank discount yield: (1000 - 990)/1000 x 360/60 = 6%
• Holding period yield: (1000 - 990)/990 = 1.0101%
• Effective annual yield: (1 + 1.0101%)^365/60 - 1 = 6.3047%
• Money market yield: (360 x 6%)/(360 - 60 x 6%) = 6.0606%

If we know HPY, then:

• EAY = (1 + HPY)^365/t - 1
• r_MM = HPY x 360/t

If we know EAY, then:

• HPY = ( 1 + EAY)^t/365 - 1
• r_MM = [(1 + EAY)^t/365 - 1] x (360/t)

If we know r_MM, then:

• HPY = r_MM x (t/360)
• EAY = (1 + r_MM x t/360)^365/t - 1
  
  

  Learning Outcome Statements

  e. calculate and interpret the bank discount yield, ho

...

Periodic bond yields for both straight and zero-coupon bonds are conventionally computed based on semi-annual periods, as U.S. bonds typically make two coupon payments per year. For example, a zero-coupon bond with a maturity of five years will mature in 10 6-month periods. The periodic yield for that bond, r, is indicated by the equation Price = Maturity value x (1 + r)^-10. This yield is an internal rate of return with semi-annual compounding. How do we annualize it?

The convention is to double it and call the result the bond's yield to maturity. This method ignores the effect of compounding semi-annual YTM, and the YTM calculated in this way is called a bond-equivalent yield (BEY).

However, yields of a semi-annual-pay and an annual-pay bond cannot be compared directly without conversion. This conversion can be done in one of the two ways:

• Convert the bond-equivalent yield of a semi-annual-pay bond to an annual-pay bond.
  

• Convert the equivalent annual yield of an annual-pay bond to a bond-equivalent yield.
  

Example

• A Eurobond pays coupon annually. It has an annual-pay YTM of 8%.
• A U.S. corporate bond pays coupon semi-annually. It has a bond equivalent YTM of 7.8%.
• Which bond is more attractive, if all other factors are equal?

Solution 1

• Convert the U.S. corporate bond's bond equivalent yield to an annual-pay yield:
• Annual-pay yield = [1 + 0.078/2]² - 1 = 7.95% < 8%
• The Eurobond is more attractive since it offers a higher annual-pay yield.

Solution 2

• Convert the Eurobond's annual-pay yield to a bond equivalent yield (BEY):
• BEY = 2 x [(1 + 0.08)^0.5 - 1] = 7.85% > 7.8%
• The Eurobond is more attractive since it offers a higher bond equivalent yield.

Restrictions on debt regulate the issue of additional debt. Maximum acceptable debt usage ratios (sometimes called leverage ratios or gearing ratios) and minimum acceptable interest coverage ratios are frequently specified, permitting new debt to be issued only when justified by the issuer’s financial condition.

Negative pledges prevent the issuance of debt that would be senior to or rank in priority ahead of the existing bondholders’ debt.

Restrictions on prior claims protect unsecured bondholders by preventing the issuer from using assets that are not collateralized (called unencumbered assets) to become collateralized.

Restrictions on distributions to shareholders restrict dividends and other payments to shareholders such as share buy-backs (repurchases). The restriction typically operates by reference to the borrower’s profitability; that is, the covenant sets a base date, usually at or near the time of the issue, and permits dividends and share buy-backs only to the extent of a set percentage of earnings or cumulative earnings after that date.

Restrictions on asset disposals set a limit on the amount of assets that can be disposed by the issuer during the bond’s life. The limit on cumulative disposals is typically set as a percentage of a company’s gross assets. The usual intent is to protect bondholder claims by preventing a break-up of the company.

Restrictions on investments constrain risky investments by blocking speculative investments. The issuer is essentially forced to devote its capital to its going-concern business. A companion covenant may require the issuer to stay in its present line of business.

Restrictions on mergers and acquisitions prevent these actions unless the company is the surviving company or unless the acquirer delivers a supplemental indenture to the trustee expressly assuming the old bonds and terms of the old indenture. These requirements effectively prevent a company from avoiding its obligations to bondholders by selling out to another company.

IFRS require companies to present classified balance sheets that show current and non-current assets and current and non-current liabilities as separate classifications.However, IFRS do not prescribe a particular ordering or format, and the order in which companies present their balance sheet items is largely a function of tradition

under IFRS, a company can present a single statement of comprehensive income or as two statements, an income statement and a statement of comprehensive income that begins with profit or loss from the income statement.

3.1.5. Financial Notes and Supplementary Schedules

The notes (also sometimes referred to as footnotes) that accompany the four financial statements are required and are an integral part of the complete set of financial statements. The notes provide information that is essential to understanding the information provided in the primary statements. Volkswagen’s 2009 financial statements, for example, include 91 pages of notes.

The notes disclose the basis of preparation for the financial statements. For example, Volkswagen discloses in its first note that its fiscal year corresponds to the calendar year, that its financial statements are prepared in accordance with IFRS as adopted by the European Union, that the statements are prepared in compliance with German law, that the statements are denominated in millions of euros unless otherwise specified, and that the figures have been rounded, which might give rise to minor discrepancies when figures are added. Volkswagen also discloses that its financial statements are on a consolidated basis—that is, including Volkswagen AG and all of the subsidiary companies it controls.

The notes also disclose information about the accounting policies, methods, and estimates used to prepare the financial statements. As will be discussed in later readings, both IFRS and US GAAP allow some flexibility in choosing among alternative policies and methods when accounting for certain items. This flexibility aims to meet the divergent needs of many businesses for reporting a variety of economic transactions. In addition to differences in accounting policies and methods, differences arise as a result of estimates needed to record and measure transactions, events, and financial statement line items.

Overall, flexibility in accounting choices is necessary because, ideally, a company will select those policies, methods, and estimates that are allowable and most relevant and that fairly reflect the unique economic environment of the company’s business and industry. Flexibility can, however, create challenges for the analyst because the use of different policies, methods, and estimates reduces comparability across different companies’ financial statements. Comparability occurs when different companies’ information is measured and reported in a similar manner over time. Comparability helps the analyst identify and analyze the real economic differences across companies, rather than differences that arise solely from different accounting choices. Because comparability of financial statements is a critical requirement for objective financial analysis, an analyst should be aware of the potential for differences in accounting choices even when comparing two companies that use the same set of accounting standards.

For example, if a company acquires a piece of equipment to use in its operations, accounting standards require that the cost of the equipment be reported as an expense by allocating its cost less any residual value in a systematic manner over the equipment’s useful life. This allocation of the cost is known as depreciation. Accounting standards permit flexibility, however, in determining the manner in which each year’s expense is determined. Two companies may acquire similar equipment but use different methods and assumptions to record the expense over time. An analyst’s ability to compare the companies’ performance is hindered by the difference. Analysts must understand reporting choices in order to make appropriate adjustments when comparing companies’ financial positions and performance.

A company’s significant accounting choices (policies, methods, and estimates) must be discussed in the notes to the financial statements. For example, a note containing a summary of significant accounting policies includes how the company recognizes its revenues and depreciates its non-current t

...

if a company acquires a piece of equipment to use in its operations, accounting standards require that the cost of the equipment be reported as an expense by allocating its cost less any residual value in a systematic manner over the equipment’s useful life. This allocation of the cost is known as depreciation . Accounting standards permit flexibility, however, in determining the manner in which each year’s expense is determined. Two companies may acquire similar equipment but use different methods and assumptions to record the expense over time. An analyst’s ability to compare the companies’ performance is hindered by the difference. Analysts must understand reporting choices in order to make appropriate adjustments when comparing companies’ financial positions and performance.

Exhibit 9. Excerpt from Notes to the Consolidated Financial Statements of the Volkswagen Group for Fiscal Year Ended 31 December 2009: Selected Data on Operating Segments (€ millions)

2008	Passenger Cars and Light Commercial Vehicles	Scania	Volkswagen Financial Services	Total Segments
Sales revenue from external customers	98,710	3,865	10,193	112,768
Segment profit or loss	6,431	417	893	7,741
Segment assets	91,458	10,074	74,690	176,222

2009	Passenger Cars and Light Commercial Vehicles	Scania	Volkswagen Financial Services	Total Segments
Sales revenue from external customers	86,297	6,385	11,095	103,777
Segment profit or loss	2,020	236	606	2,862
Segment assets	87,786	9,512	76,431	173,729

An analyst uses a significant amount of judgment in deciding how to incorporate information from note disclosures into the analysis. For example, such information as financial instrument risk, contingencies, and legal proceedings can alert an analyst to risks that can affect a company’s financial position and performance in the future and that require monitoring over time. As another example, information about a company’s operating segments can be useful as a means of quickly understanding what a company does and how and where it earns money. The operating segment data shown in Exhibit 9 appear in the notes to the financial statements for Volkswagen. (The totals of the segment data do not equal the amounts reported in the company’s financial statements because the financial statement data are adjusted for intersegment activities and unallocated items. The note provides a complete reconciliation of the segment data to the reported data.) From the data in Exhibit 9, an analyst can quickly see that most of the company’s revenues and operating profits come from the sale of passenger cars and light commercial vehicles. Over 80 percent of the company’s revenues was generated by this segment in both years. In 2008, this segment accounted for over 80 percent of the company’s total segment operating profits, although the percentage declined to 70 percent in 2009 because of higher sales growth in the other two segments. Experience using the disclosures of a company and its competitors typically enhances an analyst’s judgment about the relative importance of different disclosures and the ways in which they can be helpful.

Management Commentary or Management’s Discussion and Analysis

Publicly held companies typically include a section in their annual reports where management discusses a variety of issues of concern, including the nature of the business, past results, and future outlook. This section is referred to by a variety of names, including management report(ing), management commentary, operating and financial review, and management’s discussion and analysis. Inclusion of a management report is recommended by the International Organization of Securities Commissions and frequently required by regulatory authorities, such as the US Securities and Exchange Commission (SEC) or the UK Financial Reporting Council (FRC). In Germany, management reporting has been required since 1931 and is audited. The discussion by management is arguably one of the most useful parts of a company’s annual report besides the financial statements themselves; however, other than excerpts from the financial statements, information included in the management commentary is typically unaudited. When using information from the management report, an analyst should be aware of whether the information is audited or unaudited.

To help improve the quality of the discussion by management, the International Accounting Standards Board (IASB) issued an exposure draft in June 2009 that proposed a framework for the preparation and presentation of management commentary. Per the exposure draft, that framework will provide guidance rather than set forth requirements in a standard. The exposure draft identifies five content elements of a “decision-useful management commentary.” Those content elements include 1) the nature of the business; 2) management’s objectives and strategies; 3) the company’s significant resources, risks, and relationships; 4) results of operations; and 5) critical performance measures.

In the United States, the SEC requires listed companies to provide an MD&A and specifies the content.7Management must highlight any favorable or unfavorable trends and identify significant events and uncertainties that affect the company’s liquidity, capital resources, and results of operations. The MD&A must also provide information about the effects of inflation, changing prices, or other material events and uncertainties that may cause the future operating results and financial condition to materially depart from the current reported financial information. In addition, the MD&A must provide information about off-balance-sheet obligations and aboutcontractual commitments such as purchase obligations. Companies should also provide disclosure in the MD&A that discusses the critical accounting policies that require management to make subjective judgments and that have a significant impact on reported financial results.

The management commentary or MD&A is a good starting place for understanding information in the financial statements. In particular, the forward-looking disclosures in an MD&A, such as those about planned capital expenditures, new store openings, or divestitures, can be useful in projecting a company’s future performance. However, the commentary is only one input for the analyst seeking an objective and independent perspective on a company’s performance and prospects.

The management report in the Annual Report 2009 of Volkswagen Group includes much information of potential interest to an analyst. The 78-page management report contains sections titled Business Development; Shares and Bonds; Net Assets; Financial Position; Results of Operations; Volkswagen AG (condensed, according to German Commercial Code); Value-Enhancing Factors; Risk Report; and Report on Expected Developments.

Statistics can refer to numerical data (e.g., a company's average revenue for the past 20 years). It can also refer to methods of collecting, classifying, analyzing, and interpreting numerical data. Statistical methods provide a powerful set of tools for making decisions in business and other fields.

Statistics involves two different processes:

• Describing sets of data. Descriptive statistical methods can be used to describe the important aspects of data sets that have been collected. This reading will focus on the use of descriptive statistics to consolidate a mass of numerical data into useful information.
• Drawing conclusions (making estimates, judgments, predictions, etc.). Inferential statistical methods can be used to draw conclusions about a large group from a smaller group actually observed.

We use statistical methods to analyze the results of data. Since the amount of information available may be vast, it may be extremely time-consuming and expensive to collect all the necessary data. For instance, suppose we are interested in the durability of tennis balls. Theoretically, in order to carry out an accurate assessment, we would need to collect large quantities of all different makes of tennis balls from all over the world. Clearly, this is not practical; aside from taking up lots of time, it would be cost-prohibitive to purchase all the balls we would need for our study. A more practical solution would be to use a sample.

A population consists of an entire set of objects, observations, or scores that have something in common. It comprises every possible member of the specified group. In our example above, the population of tennis balls consists of every tennis ball that has ever been manufactured anywhere in the world. This is a huge number of tennis balls. Another example of a population would be all males between the ages of 15 and 18.

A sample is a subset of a population. The sample is comprised of some of the members of the population. Since it is usually impractical (or too expensive or time-consuming) to test every member of a population, using data gathered from a sample of the population is typically the best approach available for describing that population.

In our example above, a sample might be a selection of 1,000 tennis balls of various makes collected from different sources. It would be a virtually impossible task to collect every possible tennis ball in the world; this same size provides a manageable number to work with as well as a substantial amount of possible data.

Before we move on, there are several points worth noting:

• Don't be fooled by the word "population." This does not necessarily refer to people. As with the example above, we can have a population of tennis balls. A population can consist of anything, living or not.
• Although populations are often vast, they can also be of manageable size. For example, the population of even numbers between 1 and 9 would comprise the numbers 2, 4, 6 and 8. In this case, it is possible to sample the entire population and get accurate results. This is rare, however, and for your purposes, populations can generally be considered to be vast.
• In general, the bigger the sample, the better your results will be (because you are using data from more of the population for analysis). However, this point can present difficulties, as you will see when we study variance and standard deviation later.
• The ideal process would be to select a sample that is "representative" of the population (a sample that takes into account extreme values on both sides but contains many "average" values). In this way, the results that we get will be more meaningful. Because we frequently don't know about the exact values of a population (which is why we sample in the first place), we will never really know if our sample is truly representative or not. It's a

...

Statistics can refer to numerical data (e.g., a company's average revenue for the past 20 years). It can also refer to methods of collecting, classifying, analyzing, and interpreting numerical data. Statistical methods provide a powerful set of tools for making decisions in business and other fields.

Statistics involves two different processes:

• Describing sets of data. Descriptive statistical methods can be used to describe the important aspects of data sets that have been collected. This reading will focus on the use of descriptive statistics to consolidate a mass of numerical data into useful information.
• Drawing conclusions (making estimates, judgments, predictions, etc.). Inferential statistical methods can be used to draw conclusions about a large group from a smaller group actually observed.

We use statistical methods to analyze the results of data. Since the amount of information available may be vast, it may be extremely time-consuming and expensive to collect all the necessary data. For instance, suppose we are interested in the durability of tennis balls. Theoretically, in order to carry out an accurate assessment, we would need to collect large quantities of all different makes of tennis balls from all over the world. Clearly, this is not practical; aside from taking up lots of time, it would be cost-prohibitive to purchase all the balls we would need for our study. A more practical solution would be to use a sample.

A population consists of an entire set of objects, observations, or scores that have something in common. It comprises every possible member of the specified group. In our example above, the population of tennis balls consists of every tennis ball that has ever been manufactured anywhere in the world. This is a huge number of tennis balls. Another example of a population would be all males between the ages of 15 and 18.

A sample is a subset of a population. The sample is comprised of some of the members of the population. Since it is usually impractical (or too expensive or time-consuming) to test every member of a population, using data gathered from a sample of the population is typically the best approach available for describing that population.


In our example above, a sample might be a selection of 1,000 tennis balls of various makes collected from different sources. It would be a virtually impossible task to collect every possible tennis ball in the world; this same size provides a manageable number to work with as well as a substantial amount of possible data.

Before we move on, there are several points worth noting:

• Don't be fooled by the word "population." This does not necessarily refer to people. As with the example above, we can have a population of tennis balls. A population can consist of anything, living or not.
• Although populations are often vast, they can also be of manageable size. For example, the population of even numbers between 1 and 9 would comprise the numbers 2, 4, 6 and 8. In this case, it is possible to sample the entire population and get accurate results. This is rare, however, and for your purposes, populations can generally be considered to be vast.
• In general, the bigger the sample, the better your results will be (because you are using data from more of the population for analysis). However, this point can present difficulties, as you will see when we study variance and standard deviation later.
• The ideal process would be to select a sample that is "representative" of the population (a sample that takes into account extreme values on both sides but contains many "average" values). In this way, the results that we get will be more meaningful. Because we frequently don't know about the exact values of a population (which is why we sample in the first place), we will never really know if our sample is truly representative or not. It's all we have to work with, however, so it's all we can use.
• Some populations are only hypothetical. Consider an experimenter interested in the possible effectiveness of a new teaching method for reading. He or she might define a population as the reading achievement scores that would result if all 6-year olds in the U.S. were taught with this new method. The population is hypothetical in the sense that there is not a group of students who have been taught using the new method; the population consists of the scores that would be obtained if they were taught with this method.

Both large groups of data (populations) and smaller groups (samples) have values associated with them, such as the average of all values in a sample and the average of all population values. Values from a population are called parameters, and values from a sample are called statistics.

A parameter is a numerical quantity measuring some aspect of a population of scores.

• The mean, for example, is a measure of central tendency.
• Greek letters are used to designate parameters.
• Parameters are rarely known and are usually estimated by statistics computed in samples.
• Populations can have many parameters, but investment analysts are usually only concerned with a few, such as the mean return or the standard deviation of returns.

Estimates of these parameters taken from a sample are called statistics. Much of the field of statistics is devoted to drawing inferences from a sample concerning the value of a population parameter.

A statistic is defined as a numerical quantity (such as the mean) calculated in a sample. It has two different meanings.

• Most commonly, statistics refers to numerical data such as a company's earnings per share or average returns over the past five years.
• Statistics can also refer to the process of collecting, organizing, presenting, analyzing, and interpreting numerical data for the purpose of making decisions.

Note that we will always know the exact composition of our sample, and by definition, we will always know the values within our sample. Ascertaining this information is the purpose of samples. Sample statistics will always be known, and can be used to estimate unknown population parameters.

Hint: One way to easily remember these terms is to recall that "population" and "parameter" both start with a "p," and "sample" and "statistic" both start with a "s."

Inferential statistics generally require that sampling be random although some types of sampling (such as those used in voter polling) seek to make the sample as representative of the population as possible by choosing a sample that resembles the population on most important characteristics.

A typical statistical procedure:

• Define the population and identify the parameter(s) of interest.
• Draw a sample from the population.
• Determine the corresponding statistic(s) of the sample and use it (or them) to estimate the parameter(s) of the population.

Measurement is the assignment of numbers to objects or events in a systematic fashion. To choose the appropriate statistical methods for summarizing and analyzing data, we need to distinguish between different measurement scales or levels of measurement.

• Nominal Scale
  • Nominal measurement represents the weakest level of measurement.
  • It consists of assigning items to groups or categories.
  • No quantitative information is conveyed and no ordering (ranking) of the items is implied.
  • Nominal scales are qualitative rather than quantitative.
  Religious preference, race, and sex are all examples of nominal scales. Another example is portfolio managers categorized as value or growth style will have a scale of 1 for value and 2 for growth. Frequency distributions are usually used to analyze data measured on a nominal scale. The main statistic computed is the mode. Variables measured on a nominal scale are often referred to as categorical or qualitative variables.

• Ordinal Scale
  • Measurements on an ordinal scale are categorized.
  • The various measurements are then ranked in their categories.
  • Measurements with ordinal scales are ordered with higher numbers representing higher values. The intervals between the numbers are not necessarily equal.
  Example 1
  On a 5-point rating scale measuring attitudes toward gun control, the difference between a rating of 2 and a rating of 3 may not represent the same difference as that between a rating of 4 and a rating of 5.
  Example 2
  Two categories might be value and growth. Within each category, the portfolio managers measured will be weighted according to performance on a scale from 1 to 10, with 1 being the best- and 10 the worst-performing manager.
  There is no "true" zero point for ordinal scales, since the zero point is chosen arbitrarily. The lowest point on the rating scale in the example was arbitrarily chosen to be 1. It could just as well have been 0 or -5.

• Interval Scale
  Interval scales rank measurements and ensure that the intervals between the rankings are equal. Scale values can be added and subtracted from each other.
  For example, if anxiety was measured on an interval scale, a difference between a score of 10 and a score of 11 would represent the same difference in anxiety as the difference between a score of 50 and a score of 51.
  Interval scales do not have a "true" zero point. Therefore, it is not possible to make statements about how many times higher one score is than another. For the anxiety example, it would not be valid to say that a person with a score of 30 was twice as anxious as a person with a score of 15. True interval measurement is somewhere between rare and nonexistent in the behavioral sciences. No interval scales measuring anxiety, such as the one described in the example, actually exist. A good example of an interval scale is the Fahrenheit measure of temperature. Equal differences on this scale represent equal differences in temperature, but a temperature of 30°F is not twice as warm as one of 15°F.

• Ratio Scale
  Ratio scales are like interval scales except that they have true zero points. This is the strongest measurement scale. In addition to permitting ranking and addition or subtraction, ratio scales allow computation of meaningful ratios. A good example is the Kelvin scale of temperature. This scale has an absolute zero. Thus, a temperature of 300°K is twice as high as a temperature of 150°K. Two financial examples of ratio scales are rates of return and money. Both examples can be measured on a zero scale, where zero represents no return, or in the case of money, no money.

Note that as you move down t...

Measurement is the assignment of numbers to objects or events in a systematic fashion. To choose the appropriate statistical methods for summarizing and analyzing data, we need to distinguish between different measurement scales or levels of measurement.

Nominal Scale

• Nominal measurement represents the weakest level of measurement.
• It consists of assigning items to groups or categories.
• No quantitative information is conveyed and no ordering (ranking) of the items is implied.
• Nominal scales are qualitative rather than quantitative.

Religious preference, race, and sex are all examples of nominal scales. Another example is portfolio managers categorized as value or growth style will have a scale of 1 for value and 2 for growth. Frequency distributions are usually used to analyze data measured on a nominal scale. The main statistic computed is the mode. Variables measured on a nominal scale are often referred to as categorical or qualitative variables.

Ordinal Scale

• Measurements on an ordinal scale are categorized.
• The various measurements are then ranked in their categories.
• Measurements with ordinal scales are ordered with higher numbers representing higher values. The intervals between the numbers are not necessarily equal.

Example 1

On a 5-point rating scale measuring attitudes toward gun control, the difference between a rating of 2 and a rating of 3 may not represent the same difference as that between a rating of 4 and a rating of 5.

Example 2

Two categories might be value and growth. Within each category, the portfolio managers measured will be weighted according to performance on a scale from 1 to 10, with 1 being the best- and 10 the worst-performing manager.

There is no "true" zero point for ordinal scales, since the zero point is chosen arbitrarily. The lowest point on the rating scale in the example was arbitrarily chosen to be 1. It could just as well have been 0 or -5.

Interval Scale

Interval scales rank measurements and ensure that the intervals between the rankings are equal. Scale values can be added and subtracted from each other.

For example, if anxiety was measured on an interval scale, a difference between a score of 10 and a score of 11 would represent the same difference in anxiety as the difference between a score of 50 and a score of 51.

Interval scales do not have a "true" zero point. Therefore, it is not possible to make statements about how many times higher one score is than another. For the anxiety example, it would not be valid to say that a person with a score of 30 was twice as anxious as a person with a score of 15. True interval measurement is somewhere between rare and nonexistent in the behavioral sciences. No interval scales measuring anxiety, such as the one described in the example, actually exist. A good example of an interval scale is the Fahrenheit measure of temperature. Equal differences on this scale represent equal differences in temperature, but a temperature of 30°F is not twice as warm as one of 15°F.

Hint: Remember the order of the different scales by remembering NOIR (the French word for black); the first letter of each word in the scale is indicated by the letters in the word NOIR.

Ratio Scale

Ratio scales are like interval scales except that they have true zero points. This is the strongest measurement scale. In addition to permitting ranking and addition or subtraction, ratio scales allow computation of meaningful ratios. A good example is the Kelvin scale of temperature. This scale has an absolute zero. Thus, a temperature of 300°K is twice as high as a temperature of 150°K. Two financial examples of ratio scales are rates of return and money. Both examples can be measured on a zero scale, where zero represents no return, or in the case of money, no money.

Before we move on, here's a quick exercise to make sure that you understand the different measurement scales. In each case, identify whether you think the data is nominal, ordinal, interval or ratio:

• The number of goals scored by a soccer player in a season.
• The temperature in Fahrenheit.
• The relative positions of contestants in a beauty pageant.
• The speed at which a vehicle travels.
• The allocation of the number "1" to boys and "2" to girls in a class.

Answers and Explanations

• Ratio: numbers have meaning and can't go below 0.
• Interval: temperature is always measured on the interval scale.
• Ordinal: relative positions are ranks, so this data has been ranked.
• Ratio: speed is a meaningful number and cannot be negative.
• Nominal: the numbers are labels, and have no other meaning.

Very often, the data available is vast, leading to a situation where dealing with individual numbers becomes laborious and messy. In such circumstances, it is neater and more convenient to summarize results into what is known as a frequency table. The data in the display is called a frequency distribution.

An interval, also called a class, is a set of values within which an observation falls.

• Each interval has a lower limit and an upper limit.
• Intervals must be all-inclusive and non-overlapping.

A frequency distribution is a tabular display of data categorized into a small number of non-overlapping intervals. Note that:

• Each observation can only lie in one interval.
• The total number of intervals will incorporate the whole population.
• The range for an interval is unique. This means a value (observation) can only fall into one interval.

It is important to consider the number of intervals to be used. If too few intervals are used, too much data may be summarized and we may lose important characteristics; if too many intervals are used, we may not summarize enough.

A frequency distribution is constructed by dividing the scores into intervals and counting the number of scores in each interval. The actual number of scores and the percentage of scores in each interval are displayed. This helps in the analysis of large amount of statistical data, and works with all types of measurement scales.

• Absolute frequency is the actual number of observations in a given interval.

• Relative frequency is the result of dividing the absolute frequency of each return interval by the total number of observations.

• Cumulative absolute frequency and cumulative relative frequency are the results from cumulating the absolute and relative frequencies as we move from the first to the last interval.

The following steps are required when organizing data into a frequency distribution together with suggestions on constructing the frequency distribution.

• Identify the highest and lowest values of the observations.

• Setup classes (groups into which data is divided). The classes must be mutually exclusive and of equal size.

• Add up the number of observations and assign each observation to its class.

• Count the number of observations in each class. This is called the class frequency.

Data can be divided into two types: discrete and continuous.

• Discrete: The values in the data set can be counted. There are distinct spaces between the values, such as the number of children in a family or the number of shares comprising an index.
• Continuous: The values in the data set can be measured. There are normally lots of decimal places involved and (theoretically, at least) there are no gaps between permissible values (i.e., all values can be included in the data set). Examples would include the height of a person and the time to complete an assignment. These values can be measured using sufficiently accurate tools to numerous decimal places.

There are two methods that graphically represent continuous data: histograms and frequency polygons.

1. A histogram is a bar chart that displays a frequency distribution. It is constructed as follows:

• The class frequencies are shown on the vertical (y) axis (by the heights of bars drawn next to each other).
• The classes (intervals) are shown on the horizontal (x) axis.
• There is no space between the bars.

...

A fixed income security is a financial obligation of an entity (the issuer) that promises to pay a specified sum of money at specified future date.

Issuers of bonds include supranational organizations, sovereign governments, non-sovereign governments, quasi-government entities, and corporate issuers. The risk of the issuer failing to make full and timely payments of interest and/or repayment of principal is called credit risk. Credit risk is inherent in all debt investments.

The maturity date is the date when the bond issuer is obligated to pay the outstanding principal amount. It defines the remaining life of the bond.

• It defines the time period over which the bondholder can expect to receive interest payments and principal repayment.
• It affects the yield on a bond.
• It affects the price volatility of the bond resulting from changes in interest rates: the longer the maturity, the greater the price volatility.

The par value (principal, face value, redemption value, or maturity value) is the amount that the issuer agrees to repay the bondholder on the maturity date.

• Bonds can have any par value, though a par value of $1,000 is the most common.
• The price of a bond is typically quoted as a percentage of its par value. For example, a value of 90 means 90% of the par value.
• A bond may trade above (trading at a premium) or below (trading at a discount) its par value.

The interest rate that the issuer agrees to pay each year is called the coupon rate (or nominal rate). The coupon is the annual amount of the interest payment: par value x coupon rate.

In the U.S. most issuers pay the coupon semi-annually.

If you have a "6.5 of 12/1/2019 trading at 97," you have a bond that has a 6.5 coupon rate, matures on 12/1/2019 and is selling for 97% of its par value.

A floating-rate security's coupon payments are reset periodically according to some reference rate. The typical coupon formula is: coupon rate = reference rate + quoted margin.

• Examples of reference rates are LIBOR, U.S. Treasury yields.
• The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. It is a constant value and can be positive or negative. It is often quoted in basis points.
• The coupon rate is determined at the coupon reset date but paid at the next coupon date.

A zero-coupon bond promises to pay a stipulated principal amount at a future maturity date, but it does not promise to make any interim interest payments. The value of a zero-coupon bond increases overtime, and approaches par value at maturity. The return on the bond is the difference between what the investor pays for the bond at the time of purchase and the principal payment at maturity. The implied interest rate is earned at maturity.

For example, if an investor purchases a zero-coupon bond for $60 with a par value of $100, the investor will earn $40 of interest over the life of the bond. The investor receives no payments until maturity of the bond when he or she will receive $100.

Bonds can be issued in any currency. If an issue has coupon payments in one currency and principal payments in another currency, it is called dual-currency issue. The holders of currency option bonds can choose the currency in which coupons and principals are paid.

An indenture is the contract between the issuer and the bondholder specifying the issuer's legal requirements. It contains the promises of the issuer and the rights of the holder of the bond.

Bondholders may have great difficulty in ascertaining whether the issuer has been fulfilling its obligations specified in the indenture. The indenture is thus made out to a third-party trustee as a representative of the interests of the bondholders; a trustee acts in a fiduciary capacity for bondholders.

Legal Identity of the Bond Issuer and its Legal Form

The issuer is identified in the indenture by its legal name. It is obligated to make timely payments of interest and repayment of principal. Bonds can be issued by a subsidiary of a parent legal entity. They can also be issued by a holding company. A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by assets transferred from its sponsor. If bankruptcy occurs, the sponsor's creditors cannot go after such assets; this is known as bankruptcy remote.

Source of Repayment Proceeds

The source of repayment proceeds varies, depending on the type of bond.

• Supranational bonds: repayment of previously loans, or the paid-in capital from members
• Sovereign bonds: taxing authority and money creation
• Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
• Corporate bonds: the issuer's operating cash flows
• Securitized bonds: cash flows from the underlying financial assets

Asset or Collateral Backing

Collateral backing can increase a bond issuer's credit quality.

• Seniority ranking affect credit. In general, secured debt takes priority over unsecured debt if the issuer goes bankrupt. Within unsecured debt, senior debt ranks ahead of subordinated debt. Debentures can be either secured or unsecured.
• Types of collateral backing include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.

An unsecured bond is not secured by collateral.

Covered bonds are debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.

Credit Enhancement

Credit enhancement reduces credit risks. Internal credit enhancement considerations include:

• Tranche structure. The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.
• Overcollateralization. The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.
• Excess spread. Underlying assets support a higher level of payment than that promised to security holders.

External credit enhancements are financial guarantees from third parties. Examples include surety bonds, bank guarantees, and letters of credit. If the third-party defaults, the external credit enhancement will fail. A cash collateral account can mitigate this concern.

Bond Covenants

Affirmative covenants set forth certain actions that borrowers must take, such as:

• Paying interest and principal on a timely basis
• Paying taxes and other claims when due
• Keeping assets in good conditions and in working order
• Submitting periodic rep

...

An important consideration for investors is where the bonds are issued and traded; this affects applicable laws, regulations, and tax status.

The bond market can be classified into two markets: an internal market and an external market.

Internal Bond Market

The internal bond market is also called the national bond market. It is divided into two parts: the domestic bond market and the foreign bond market. The domestic bond market is where domestic issuers issue bonds and where these bonds are subsequently traded.

A foreign bond (called a Yankee bond in the U.S., a Samurai bond in Japan, and a Bulldog bond in the U.K.) is a bond issued in a country's national bond market by an issuer not domiciled in the country where those bonds are subsequently traded.

• Regulatory authorities in the country where the bond is issued impose rules governing the issuance of foreign bonds.
• Issuers of foreign bonds include national governments and their subdivisions, corporations, andsupranationals (entities formed by two or more central governments through international treaties).
• They can be denominated in any currency.
• They can be publicly issued or privately placed.

External Bond Market

This market is also referred to as the international bond market, the offshore bond market, or the Eurobond market. The bonds in this market are:

• underwritten by an international syndicate.
• offered simultaneously to investors in a number of countries at issuance.
• issued outside the jurisdiction of any single country. Therefore, they are not registered through a regulatory agency.
• in unregistered form.

Eurobonds are subject to a lower level of listing, disclosure, and regulatory requirements than domestic or foreign bonds.

Eurobonds are classified according to the currency in which the issue is denominated. For example, if a Eurobond is denominated in U.S. dollars, it is called a Eurodollar bond. A USD bond issued by Ford and sold in Japan is thus called a Eurodollar bond, not a Euroyen bond.

A global bond is a debt obligation that is issued and traded in both the Eurobond market and at least one domestic market (for example, a USD bond issued by the Canadian government sold in the U.S. and Japan). Issuers of global bonds typically have high credit quality, and regularly have large fund needs. The first global bond was issued by the World Bank.

Tax Considerations

In general the income portion of a bond is taxed at the ordinary tax rate. Some countries implement a capital gains tax. Some countries even differentiate between long-term and short-term capital gains. There may be specific tax provisions for bonds issued at a discount or bought at a premium.

Principal Repayment Structures

Bullet bond. The issuer pays the full principal amount at the maturity date.

Amortizing bond. Its payment schedule requires periodic payment of interest and repayment of principal. If the entire principal is not amortized over the life of the bond, a balloon payment is required at the end of the term.

A sinking fund arrangement allows a bond's principal outstanding amount to be repaid each year throughout the bond's life or after a specific date.

A call provision is the right of the issuer to retire the issue prior to the stated maturity date. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis.

Coupon Payment Structures

The coupon payments of a floating rate security are reset periodically (e.g. quarterly) according to a reference rate such as LIBOR.

Example

Suppose that the reference rate is the 1-month LIBOR and the quoted margin is 100 basis points: if the 1-month LIBOR on the coupon reset rate is 5%, the coupon rate is 5% + 100 basis points = 6%.

The quoted margin does not need to be a positive value. For example, it could be -90 basis points.

A floating-rate security may have upper and/or lower limits on the coupon rate. A cap is the maximum coupon rate of a floater. It is an attractive feature for the issuer since it limits the coupon rate. A floor is the minimum coupon rate, and it is an attractive feature for the investor. A collar is a floater with both a cap and floor.

For example, assume the reference rate is the 1-month LIBOR, the quoted margin is 100 basis points, and there is a cap of 7%. If the 1-month LIBOR at reset date was 6.5%, the coupon rate per the formula would be 7.5% (6.5% + 1%), but with the cap the coupon rate is restricted to 7%.

A typical floater's coupon rate increases when the reference rate increases and decreases when the reference rate decreases. However, an inverse floater's (also called a reverse floater) coupon rate moves in the opposite direction from the change in the reference rate: coupon rate = K - L x reference rate, where K and L are constant values set forth in the prospectus for the issue. To prevent a negative coupon rate there is a floor imposed.
For example, an inverse floater's coupon rate = 12% - 2 x 3-month LIBOR. If the three-month LIBOR is 2%, then the coupon rate for the next interest payment period is: 12% - 2 x 2% = 8%.

Step-up coupon bonds have low initial and gradually increasing coupon rates; that is, their coupon rates "step up" over time.

Stepped spread floaters. The quoted margins for these coupons can step to either a higher or a lower level over the security's life. For example, a five-year floating-rate note's coupon rate may be six-month LIBOR + 1% for the first two years, and three-month LIBOR + 3% for the remaining years.

Credit-linked coupon bonds. These coupons change when the issuer's credit rating changes.

Payment-in-kind coupon bonds. These coupons allow the issuer to pay coupons with additional amounts of the bond issue rather than in cash.

The payment structures for index-linked bonds vary considerably among countries. An inflation-linked bond orlinker links its coupon payments and/or principal repayments to a price index. For example, the Treasury Infla...

An embedded option is a provision in a bond indenture that gives the issuer and/or the bondholder an option to take some action against the other party. These options are embedded because they are an integral part of the bond structure. In contrast, "bare options" trade separately from any underlying security.

Embedded options may benefit either the issuer or the bondholder. An embedded option benefits the issuer if it gives the issuer a right or it puts an upper limit on the issuer's obligations. An embedded option benefits the bondholder if it gives the bondholder a right or it puts a lower limit on the bondholder's benefits.

Callable Bonds

A bond issue that permits the issuer to call or refund an issue prior to the stated maturity date is referred to as acallable bond.

• The price that the issuer must pay to retire the issue is the call price.
• Bonds can be called in whole or in part. Most of the time, an entire bond issue is called. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis. This means that each bondholder will have the same percentage of his or her holdings redeemed.
• Typically, call provisions have a deferment period; that is, the issuer may not call the bond for a number of years until a specified first call date is reached. This feature is called a deferred call.
• The issuer has no obligation for early retirement of bonds.

A call option becomes more valuable to the bond issuer when interest rates fall. If interest rates fall, the issuer can retire the bond paying a high coupon rate, and replace it with lower coupon bonds. However, call provisions are detrimental to bondholders, since proceeds can only be reinvested at a lower interest rate.

Callable bonds exercise styles:

• American call: any time starting on the first call date
• European call: once on the call date
• Bermuda-style call: on predetermined dates following the call protection period

Putable Bonds

A put option grants the bondholder the right to sell the issue back to the issuer at a specified price ("put price") on designated dates. The repurchase price is set at the time of issue, and is usually par value.

Bondholders have the option of putting bonds back to the issuer either once during the lifetime of the bond (a "one-time put bond"), or on a number of different dates. The special advantages of put bonds mean that putable bonds have lower yield than otherwise similar bonds.

The price behaviour of a putable bond is the opposite of that of a callable bond. The put option becomes more valuable when interest rates rise.

Convertible Bonds

A convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. This feature allows the bondholder to take advantage of favorable movements in the price of the issuer's common stock without having to participate in losses.

Example

Suppose you can buy a 10%, 15-year, $100 par value bond today for $110 that can be converted into 10 shares at $10 per share. The market price of stock = $8; no dividends.

• The conversion price is the price per share at which a convertible bond can be converted into common stock. In the example above, the conversion price would be $10.
• The conversion ratio is the number of common shares each bond can be converted into (in this case, 10). It is the par value / conversion price. It is determined at the time the convertible bond is issued.
• The conversion value, also known as parity value, is the market price of stock x conversion ratio ($8 x 10 = $80).
• The conversion premium is the difference between the bond's price and its conversion valu

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An indenture is the contract between the issuer and the bondholder specifying the issuer's legal requirements. It contains the promises of the issuer and the rights of the holder of the bond.

Bondholders may have great difficulty in ascertaining whether the issuer has been fulfilling its obligations specified in the indenture. The indenture is thus made out to a third-party trustee as a representative of the interests of the bondholders; a trustee acts in a fiduciary capacity for bondholders.

Legal Identity of the Bond Issuer and its Legal Form

The issuer is identified in the indenture by its legal name. It is obligated to make timely payments of interest and repayment of principal. Bonds can be issued by a subsidiary of a parent legal entity. They can also be issued by a holding company. A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by assets transferred from its sponsor. If bankruptcy occurs, the sponsor's creditors cannot go after such assets; this is known as bankruptcy remote.

Source of Repayment Proceeds

The source of repayment proceeds varies, depending on the type of bond.

• Supranational bonds: repayment of previously loans, or the paid-in capital from members
• Sovereign bonds: taxing authority and money creation
• Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
• Corporate bonds: the issuer's operating cash flows
• Securitized bonds: cash flows from the underlying financial assets

Asset or Collateral Backing

Collateral backing can increase a bond issuer's credit quality.

• Seniority ranking affect credit. In general, secured debt takes priority over unsecured debt if the issuer goes bankrupt. Within unsecured debt, senior debt ranks ahead of subordinated debt. Debentures can be either secured or unsecured.
• Types of collateral backing include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.

An unsecured bond is not secured by collateral.

Covered bonds are debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.

Credit Enhancement

Credit enhancement reduces credit risks. Internal credit enhancement considerations include:

• Tranche structure. The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.
• Overcollateralization. The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is $105 million, then the first $5 million loss will not result in a loss to any of the tranches.
• Excess spread. Underlying assets support a higher level of payment than that promised to security holders.

External credit enhancements are financial guarantees from third parties. Examples include surety bonds, bank guarantees, and letters of credit. If the third-party defaults, the external credit enhancement will fail. A cash collateral account can mitigate this concern.

Bond Covenants

Affirmative covenants set forth certain actions that borrowers must take, such as:

• Paying interest and principal on a timely basis
• Paying taxes and other claims when due
• Keeping assets in good conditions and in working order
• Submitting periodic reports to a trustee so that the trustee can evaluate the issuer's compliance with the indenture

Negative covenants set forth certain limitations and restrictions on the borrower's activities, such as:

• Limitations on the borrower's ability to incur additional debt unless certain tests are met
• Limitations on dividend payments and stock repurchases
• Limitations on the sale of assets

The legal obligation to make the contractual payments is assigned to the bond issuer. The issuer is identified in the indenture by its legal name

Equity securities play a fundamental role in investment analysis and portfolio management. The importance of this asset class continues to grow on a global scale because of the need for equity capital in developed and emerging markets, technological innovation, and the growing sophistication of electronic information exchange. Given their absolute return potential and ability to impact the risk and return characteristics of portfolios, equity securities are of importance to both individual and institutional investors.

Global equity securities have offered an average of annualized real return of 5% based on historical data, while the average annual real return is about just 1% or 2% for government bills and bonds. However, equity securities are more volatile than government bills and bonds. They represent a key asset class for global investors because of their unique return and risk characteristics.

Common Shares

Common shares represent ownership shares in a corporation.

The two most important characteristics of common shares are:

• Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
• Limited liability means that the greatest amount shareholders can lose in event of failure of the corporation is the original investment.

Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.

Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholders is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.

Cumulative voting is another procedure of voting for a company's directors. Each shareholder is entitled one vote per share times the number of directors to be elected. For example, if you owned 100 shares and there were three directors to be elected, you would have 300 votes. This is advantageous for individual investors because they can apply all of their votes toward one person.

Common shares can be callable or putable. Callable common shares give the issuer the right to buy back the shares from shareholders at a pre-determined price. Putable common shares give shareholders the right to sell the shares back to the issuer at a pre-determined price.

Preference Shares

A preferred share, also called preference share, has features similar to both equities and bonds.

• Like a bond, it promises to pay to its holder fixed dividends each year. In this sense it is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm.
• A preferred share is an equity investment, however, in the sense that failure to pay the dividend does not precipitate corporate bankruptcy. It has priority over a common share in the payment of dividends and upon liquidation.

Preferred dividends can be cumulative; that is, unpaid dividends cumulate and must be paid full before any dividends may be paid to common shareholders. All passed dividends on a cumulative stock are dividends in arrears. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared. The implication is that the dividend payments are at the company's discretion and are thus similar to payments made to common shareholders.

Participating preferred shares offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these shares receive their regular dividends regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings or profitability goals, the investors receive additional dividends. Most preferred shares are non-participating.

Convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. The fixed-income component offers a steady income stream and some protection of capital. The option to convert these preferred shares into common shares gives the investor the opportunity to gain from a rise in share price.

Common Shares

Common shares represent ownership shares in a corporation.

The two most important characteristics of common shares are:

• Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
• Limited liability means that the greatest amount shareholders can lose in event of failure of the corporation is the original investment.

Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.

Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholders is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.