on 25-Jan-2018 (Thu)

This study session begins with monetary and fiscal policy, including their use by central banks and governments. Economics in a global context is then introduced. Next follows a discussion on the flows of goods and services and physical and financial capital that occur across national borders. Highlighted in the discussion are the relationships between different types of flows and the benefits of trade to trade partners. Finally, given that operations and investments in global markets involve foreign exchange (currency) risk, the session concludes with an overview of currency market fundamentals.

This study session introduces the principal information sources used to evaluate a company’s financial performance. Primary financial statements (income statement, balance sheet, cash flow statement, and statement of changes in equity) in addition to notes to these statements and management reporting are examined. A general framework for conducting financial statement analysis is provided. The process of recording a business’s activities through the accounting process including necessary accruals and adjustments is then described. The session concludes with an explanation of the roles played by financial reporting standard-setting bodies and regulatory authorities, the Internal Accounting Standards Board’s conceptual framework, and the movement toward global accounting standards.

This study session introduces the concept of financial reporting quality. The session examines the financial reporting quality differences that may exist between companies and the means for identifying them. Warning signs of poor or low quality reporting are covered. The application of financial analysis techniques to evaluate a company’s past and projected performance, assess credit risk, and screen for potential equity investments follows. Common adjustments to reported financials to facilitate cross-company comparisons conclude the session.

This study session introduces the concept of a portfolio approach to investments. The needs of individual and institutional investors are each examined, along with the range of available investment solutions. The three main steps in the portfolio management process (planning, execution, and feedback) are outlined. A discussion of risk management, including the various types and measures of risk, follows and a risk management framework is provided. Common portfolio risk and return measures and the introduction of modern portfolio theory—a quantitative framework for asset pricing and portfolio selection—come next. The session ends with coverage of the portfolio planning and construction process, including the development of an investment policy statement.

This study session provides a structural overview of financial markets and their operating characteristics. Overview markets include equities, fixed income, derivatives, and alternative investments. Various asset types, market participants, and how assets trade within these markets and ecosystems are described. Coverage of these core asset classes continues in subsequent Level I study sessions, laying the foundation for further study in Levels II and III. The study session then turns to the calculation, construction, and use of security market indexes. A discussion of market efficiency and the degree to which market prices may reflect available information concludes the session.

This study session introduces the unique attributes that define fixed-income securities, then follows with an overview of global debt markets. Primary issuers, sectors, and bond types are explained. Key concepts for the calculation and interpretation of bond prices, yields, and spreads and coverage of interest rate risk and key related risk measures are presented. Securitization—the creation of fixed-income securities backed by certain (typically less liquid) assets—including the various types, characteristics, and risks of these investments end the session.

This study session examines the fundamental elements underlying bond returns and risks with a specific focus on interest rate and credit risk. Duration, convexity, and other key measures for assessing a bond’s sensitivity to interest rate risk are introduced. An explanation of credit risk and the use of credit analysis for risky bonds concludes the session.

As a candidate in the CFA Program, you are both expected and required to meet high ethical standards. This reading introduces ideas and concepts that will help you understand the importance of ethical behavior in the investment industry. You will be introduced to various types of ethical issues within the investment profession and learn about the CFA Institute Code of Ethics. Subsequently, you will be introduced to a framework as a way to approach ethical decision making.

Imagine that you are employed in the research department of a large financial services firm. You and your colleagues spend your days researching, analyzing, and valuing the shares of publicly traded companies and sharing your investment recommendations with clients. You love your work and take great satisfaction in knowing that your recommendations can help the firm’s investing clients make informed investment decisions that will help them meet their financial goals and improve their lives.

Several months after starting at the firm, you learn that an analyst at the firm has been terminated for writing and publishing research reports that misrepresented the fundamental risks of some companies to investors. You learn that the analyst wrote the reports with the goal of pleasing the management of the companies that were the subjects of the research reports. He hoped that these companies would hire your firm’s investment banking division for its services and he would be rewarded with large bonuses for helping the firm increase its investment banking fees. Some clients bought shares based on the analyst’s reports and suffered losses. They posted stories on the internet about their losses and the misleading nature of the reports. When the media investigated and published the story, the firm’s reputation for investment research suffered. Investors began to question the firm’s motives and the objectivity of its research recommendations. The firm’s investment clients started to look elsewhere for investment advice, and company clients begin to transfer their business to firms with untarnished reputations. With business declining, management is forced to trim staff. Along with many other hard-working colleagues, you lose your job—through no fault of your own.

Imagine how you would feel in this situation. Most people would feel upset and resentful that their hard and honest work was derailed by someone else’s unethical behavior. Yet, this type of scenario is not uncommon. Around the world, unsuspecting employees at such companies as SAC Capital, Stanford Financial Group, Everbright Securities, Enron, Satyam Computer Services, Arthur Andersen, and other large companies have experienced such career setbacks when someone else’s actions destroyed trust in their companies and industries.

Businesses and financial markets thrive on trust—defined as a strong belief in the reliability of a person or institution. In a 2013 study on trust, investors indicated that to earn their trust, the top three attributes of an investment manager should be that it (1) has transparent and open business practices, (2) takes responsible actions to address an issue or crisis, and (3) has ethical business practices. Although these attributes are valued by customers and clients in any industry, this reading will explore why they are of particular importance to the investment industry.

People may think that ethical behavior is simply about following laws, regulations, and other rules, but throughout our lives and careers we will encounter situations in which there is no definitive rule that specifies how to act, or the rules that exist may be unclear or even in conflict with each other. Responsible people, including investment professionals, must be willing and able to identify potential ethical issues and create solutions to them even in the absence of clearly stated rules.

The Standards of Practice Handbook (Handbook) provides guidance to the people who grapple with real ethical dilemmas in the investment profession on a daily basis; the Handbook addresses the professional intersection where theory meets practice and where the concept of ethical behavior crosses from the abstract to the concrete. The Handbook is intended for a diverse and global audience: CFA Institute members navigating ambiguous ethical situations; supervisors and direct/indirect reports determining the nature of their responsibilities to each other, to existing and potential clients, and to the broader financial markets; and candidates preparing for the Chartered Financial Analyst (CFA) examinations.

Recent events in the global financial markets have tested the ethical mettle of financial market participants, including CFA Institute members. The standards taught in the CFA Program and by which CFA Institute members and candidates must abide represent timeless ethical principles and professional conduct for all market conditions. Through adherence to these standards, which continue to serve as the model for ethical behavior in the investment professional globally, each market participant does his or her part to improve the integrity and efficient operations of the financial markets.

The Handbook provides guidance in understanding the interconnectedness of the aspirational and practical principles and provisions of the Code of Ethics and Standards of Professional Conduct (Code and Standards). The Code contains high-level aspirational ethical principles that drive members and candidates to create a positive and reputable investment profession. The Standards contain practical ethical principles of conduct that members and candidates must follow to achieve the broader industry expectations. However, applying the principles individually may not capture the complexity of ethical requirements related to the investment industry. The Code and Standards should be viewed and interpreted as an interwoven tapestry of ethical requirements. Through members’ and candidates’ adherence to these principles as a whole, the integrity of and trust in the capital markets are improved.

Preamble—Why Is a Global Investment Performance Standard Needed?

Standardized Investment Performance

Financial markets and the investment management industry have become increasingly global in nature. The growth in the types and number of financial entities, the globalization of the investment process, and the increased competition among investment management firms demonstrate the need to standardize the calculation and presentation of investment performance.

Global Passport

Asset managers and both existing and prospective clients benefit from an established global standard for calculating and presenting investment performance. Investment practices, regulation, performance measurement, and reporting of performance vary considerably from country to country. By adhering to a global standard, firms in countries with minimal or no investment performance standards will be able to compete for business on an equal footing with firms from countries with more developed standards. Firms from countries with established practices will have more confidence in being fairly compared with local firms when competing for business in countries that have not previously adopted performance standards. Performance standards that are accepted globally enable investment firms to measure and present their investment performance so that investors can readily compare investment performance among firms.

Investor Confidence

Investment managers that adhere to investment performance standards help assure investors that the firm’s investment performance is complete and fairly presented. Both prospective and existing clients of investment firms benefit from a global investment performance standard by having a greater degree of confidence in the performance information presented to them.

Objectives

The establishment of a voluntary global investment performance standard leads to an accepted set of best practices for calculating and presenting investment performance that is readily comparable among investment firms, regardless of geographic location. These standards also facilitate a dialogue between investment firms and their existing and prospective clients regarding investment performance.

The goals of the GIPS Executive Committee are:

• To establish investment industry best practices for calculating and presenting investment performance that promote investor interests and instill investor confidence;

• To obtain worldwide acceptance of a single standard for the calculation and presentation of investment performance based on the principles of fair representation and full disclosure;

• To promote the use of accurate and consistent investment performance data;

• To encourage fair, global competition among investment firms without creating barriers to entry; and

• To foster the notion of industry “self-regulation” on a global basis.

Overview

Key features of the GIPS standards include the following:

• The GIPS standards are ethical standards for investment performance presentation to ensure fair representation and full disclosure of investment performance. In order to claim compliance, firms must adhere to the requirements included in the GIPS standards.

• Meeting the objectives of fair representation and full disclosure is likely to require more than simply adhering to the minimum requirements of the GIPS standards. Firms should also adhere to the recommendations to achieve best practice in the calculation and presentation of performance.

• The GIPS standards require firms to include all actual, discretionary, fee-paying portfolios in at least one composite defined by investment mandate, objective, or strategy in order to pre

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In nearly all investment decisions we work with random variables. The return on a stock and its earnings per share are familiar examples of random variables. To make probability statements about a random variable, we need to understand its probability distribution. A probability distributionspecifies the probabilities of the possible outcomes of a random variable.

In this reading, we present important facts about four probability distributions and their investment uses. These four distributions—the uniform, binomial, normal, and lognormal—are used extensively in investment analysis. They are used in such basic valuation models as the Black–Scholes–Merton option pricing model, the binomial option pricing model, and the capital asset pricing model. With the working knowledge of probability distributions provided in this reading, you will also be better prepared to study and use other quantitative methods such as hypothesis testing, regression analysis, and time-series analysis.

After discussing probability distributions, we end the reading with an introduction to Monte Carlo simulation, a computer-based tool for obtaining information on complex problems. For example, an investment analyst may want to experiment with an investment idea without actually implementing it. Or she may need to price a complex option for which no simple pricing formula exists. In these cases and many others, Monte Carlo simulation is an important resource. To conduct a Monte Carlo simulation, the analyst must identify risk factors associated with the problem and specify probability distributions for them. Hence, Monte Carlo simulation is a tool that requires an understanding of probability distributions.

Before we discuss specific probability distributions, we define basic concepts and terms. We then illustrate the operation of these concepts through the simplest distribution, the uniform distribution. That done, we address probability distributions that have more applications in investment work but also greater complexity.

Each day, we observe the high, low, and close of stock market indexes from around the world. Indexes such as the S&P 500 Index and the Nikkei-Dow Jones Average are samples of stocks. Although the S&P 500 and the Nikkei do not represent the populations of US or Japanese stocks, we view them as valid indicators of the whole population’s behavior. As analysts, we are accustomed to using this sample information to assess how various markets from around the world are performing. Any statistics that we compute with sample information, however, are only estimates of the underlying population parameters. A sample, then, is a subset of the population—a subset studied to infer conclusions about the population itself.

This reading explores how we sample and use sample information to estimate population parameters. In the next section, we discuss sampling—the process of obtaining a sample. In investments, we continually make use of the mean as a measure of central tendency of random variables, such as return and earnings per share. Even when the probability distribution of the random variable is unknown, we can make probability statements about the population mean using the central limit theorem. In Section 3, we discuss and illustrate this key result. Following that discussion, we turn to statistical estimation. Estimation seeks precise answers to the question “What is this parameter’s value?”

The central limit theorem and estimation are the core of the body of methods presented in this reading. In investments, we apply these and other statistical techniques to financial data; we often interpret the results for the purpose of deciding what works and what does not work in investments. We end this reading with a discussion of the interpretation of statistical results based on financial data and the possible pitfalls in this process.

Technical analysis has been used by traders and analysts for centuries, but it has only recently achieved broad acceptance among regulators and the academic community. This reading gives a brief overview of the field, compares technical analysis with other schools of analysis, and describes some of the main tools in technical analysis. Some applications of technical analysis are subjective. That is, although certain aspects, such as the calculation of indicators, have specific rules, the interpretation of findings is often subjective and based on the long-term context of the security being analyzed. This aspect is similar to fundamental analysis, which has specific rules for calculating ratios, for example, but introduces subjectivity in the evaluation phase.

In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income, and is rooted in microeconomics, which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics.

Microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and the theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms.

It is expected that candidates will be familiar with the basic concepts of demand and supply. This material is covered in detail in the recommended prerequisite readings. In this reading, we will explore how buyers and sellers interact to determine transaction prices and quantities. The reading is organized as follows: Section 2 discusses the consumer or demand side of the market model, and Section 3 discusses the supply side of the consumer goods market, paying particular attention to the firm’s costs. Section 4 provides a summary of key points in the reading.

In the field of economics, microeconomics is the study of the economic activity and behavior of individual economic units, such as a household, a company, or a market for a particular good or service, and macroeconomics is the study of the aggregate activities of households, companies, and markets. Macroeconomics focuses on national aggregates, such as total investment, the amount spent by all businesses on plant and equipment; total consumption, the amount spent by all households on goods and services; the rate of change in the general level of prices; and the overall level of interest rates.

Macroeconomic analysis examines a nation’s aggregate output and income, its competitive and comparative advantages, the productivity of its labor force, its price level and inflation rate, and the actions of its national government and central bank. The objective of macroeconomic analysis is to address such fundamental questions as:

• What is an economy’s aggregate output, and how is aggregate income measured?

• What factors determine the level of aggregate output/income for an economy?

• What are the levels of aggregate demand and aggregate supply of goods and services within the country?

• Is the level of output increasing or decreasing, and at what rate?

• Is the general price level stable, rising, or falling?

• Is unemployment rising or falling?

• Are households spending or saving more?

• Are workers able to produce more output for a given level of inputs?

• Are businesses investing in and expanding their productive capacity?

• Are exports (imports) rising or falling?

From an investment perspective, investors must be able to evaluate a country’s current economic environment and to forecast its future economic environment in order to identify asset classes and securities that will benefit from economic trends occurring within that country. Macroeconomic variables—such as the level of inflation, unemployment, consumption, government spending, and investment—affect the overall level of activity within a country. They also have different impacts on the growth and profitability of industries within a country, the companies within those industries, and the returns of the securities issued by those companies.

This reading is organized as follows: Section 2 describes gross domestic product and related measures of domestic output and income. Section 3 discusses short-run and long-run aggregate demand and supply curves, the causes of shifts and movements along those curves, and factors that affect equilibrium levels of output, prices, and interest rates. Section 4 discusses sources, sustainability, and measures of economic growth. A summary and practice problems complete the reading.

Global investors must address two fundamentally interrelated questions: where to invest and in what asset classes? Some countries may be attractive from an equity perspective because of their strong economic growth and the profitability of particular domestic sectors or industries. Other countries may be attractive from a fixed income perspective because of their interest rate environment and price stability. To identify markets that are expected to provide attractive investment opportunities, investors must analyze cross-country differences in such factors as expected GDP growth rates, monetary and fiscal policies, trade policies, and competitiveness. From a longer term perspective investors also need to consider such factors as a country’s stage of economic and financial market development, demographics, quality and quantity of physical and human capital (accumulated education and training of workers), and its area(s) of comparative advantage.1

This reading provides a framework for analyzing a country’s trade and capital flows and their economic implications. International trade can facilitate economic growth by increasing the efficiency of resource allocation, providing access to larger capital and product markets, and facilitating specialization based on comparative advantage. The flow of financial capital (funds available for investment) between countries with excess savings and those where financial capital is scarce can increase liquidity, raise output, and lower the cost of capital. From an investment perspective, it is important to understand the complex and dynamic nature of international trade and capital flows because investment opportunities are increasingly exposed to the forces of global competition for markets, capital, and ideas.

This reading is organized as follows. Section 2 defines basic terminology used in the reading and describes patterns and trends in international trade and capital flows. It also discusses the benefits of international trade, distinguishes between absolute and comparative advantage, and explains two traditional models of comparative advantage. Section 3 describes trade restrictions and their implications and discusses the motivation for, and advantages of, trade agreements. Section 4 describes the balance of payments and Section 5 discusses the function and objectives of international organizations that facilitate trade. A summary of key points and practice problems conclude the reading.

This reading presents several important applications of financial statement analysis. Among the issues we will address are the following:

• What are the key questions to address in evaluating a company’s past financial performance?

• How can an analyst approach forecasting a company’s future net income and cash flow?

• How can financial statement analysis be used to evaluate the credit quality of a potential fixed-income investment?

• How can financial statement analysis be used to screen for potential equity investments?

• How can differences in accounting methods affect financial ratio comparisons between companies, and what are some adjustments analysts make to reported financials to facilitate comparability among companies.

The reading “Financial Statement Analysis: An Introduction” described a framework for conducting financial statement analysis. Consistent with that framework, prior to undertaking any analysis, an analyst should explore the purpose and context of the analysis. The purpose and context guide further decisions about the approach, the tools, the data sources, and the format in which to report results of the analysis, and also suggest which aspects of the analysis are most important. Having identified the purpose and context, the analyst should then be able to formulate the key questions that the analysis must address. The questions will suggest the data the analyst needs to collect to objectively address the questions. The analyst then processes and analyzes the data to answer these questions. Conclusions and decisions based on the analysis are communicated in a format appropriate to the context, and follow-up is undertaken as required. Although this reading will not formally present applications as a series of steps, the process just described is generally applicable.

Section 2 of this reading describes the use of financial statement analysis to evaluate a company’s past financial performance, and Section 3 describes basic approaches to projecting a company’s future financial performance. Section 4 presents the use of financial statement analysis in assessing the credit quality of a potential debt investment. Section 5 concludes the survey of applications by describing the use of financial statement analysis in screening for potential equity investments. Analysts often encounter situations in which they must make adjustments to a company’s reported financial results to increase their accuracy or comparability with the financials of other companies. Section 6 illustrates several common types of analyst adjustments. Section 7 presents a summary, and practice problems in the CFA Institute multiple-choice format conclude the reading.

This reading presents elementary topics in leverage. Leverage is the use of fixed costs in a company’s cost structure. Fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.

Analysts refer to the use of fixed costs as leverage because fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses.

Analysts need to understand a company’s use of leverage for three main reasons. First, the degree of leverage is an important component in assessing a company’s risk and return characteristics. Second, analysts may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals also helps the analyst evaluate the quality of management’s decisions. Third, the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage should help in forecasting cash flows and in selecting an appropriate discount rate for finding their present value.

The reading is organized as follows: Section 2 introduces leverage and defines important terms. Section 3 illustrates and discusses measures of operating leverage and financial leverage, which combine to define a measure of total leverage that gauges the sensitivity of net income to a given percent change in units sold. This section also covers breakeven points in using leverage and corporate reorganization (a possible consequence of using leverage inappropriately). A summary and practice problems conclude this reading.

Risk—and risk management—is an inescapable part of economic activity. People generally manage their affairs in order to be as happy and secure as their environment and resources will allow. But regardless of how carefully these affairs are managed, there is risk because the outcome, whether good or bad, is seldom predictable with complete certainty. There is risk inherent in nearly everything we do, but this reading will focus on economic and financial risk, particularly as it relates to investment management.

All businesses and investors manage risk, whether consciously or not, in the choices they make. At its core, business and investing are about allocating resources and capital to chosen risks. In their decision process, within an environment of uncertainty, these entities may take steps to avoid some risks, pursue the risks that provide the highest rewards, and measure and mitigate their exposure to these risks as necessary. Risk management processes and tools make difficult business and financial problems easier to address in an uncertain world. Risk is not just a matter of fate; it is something that organizations can actively control with their decisions, within a risk management framework. Risk is an integral part of the business or investment process. Even in the earliest models of modern portfolio theory, such as mean–variance portfolio optimization and the capital asset pricing model, investment return is linked directly to risk but requires that risk be managed optimally. Proper identification and measurement of risk, and keeping risks aligned with the goals of the enterprise, are key factors in managing businesses and investments. Good risk management results in a higher chance of a preferred outcome—more value for the company or portfolio or more utility for the individual.

Portfolio managers need to be familiar with risk management not only to improve the portfolio’s risk–return outcome, but also because of two other ways in which they use risk management at an enterprise level. First, they help to manage their own companies that have their own enterprise risk issues. Second, many portfolio assets are claims on companies that have risks. Portfolio managers need to evaluate the companies’ risks and how those companies are addressing them.

This reading takes a broad approach that addresses both the risk management of enterprises in general and portfolio risk management. The principles underlying portfolio risk management are generally applicable to the risk management of financial and non-financial institutions as well.

The concept of risk management is also relevant to individuals. Although many large entities formally practice risk management, most individuals practice it more informally and some practice it haphazardly, oftentimes responding to risk events after they occur. Although many individuals do take reasonable precautions against unwanted risks, these precautions are often against obvious risks, such as sticking a wet hand into an electrical socket or swallowing poison. The more subtle risks are often ignored. Many individuals simply do not view risk management as a formal, systematic process that would help them achieve not only their financial goals but also the ultimate end result of happiness, or maximum utility as economists like to call it, but they should.

Although the primary focus of this reading is on institutions, we will also cover risk management as it applies to individuals. We will show that many common themes underlie risk management—themes that are applicable to both organizations and individuals.

Although often viewed as defensive, risk management is a valuable offensive weapon in the manager’s arsenal. In the quest for preferred outcomes, such as higher profit, returns, or share price, management does not usually get to choose the outcomes but does choose the risks it takes in pursuit of those outcomes. The choice of which risks to undertake through the allocation of its scarce resources is th

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Our objective in this reading is to identify the optimal risky portfolio for all investors by using the capital asset pricing model (CAPM). The foundation of this reading is the computation of risk and return of a portfolio and the role that correlation plays in diversifying portfolio risk and arriving at the efficient frontier. The efficient frontier and the capital allocation line consist of portfolios that are generally acceptable to all investors. By combining an investor’s individual indifference curves with the market-determined capital allocation line, we are able to illustrate that the only optimal risky portfolio for an investor is the portfolio of all risky assets (i.e., the market).

Additionally, we discuss the capital market line, a special case of the capital allocation line that is used for passive investor portfolios. We also differentiate between systematic and nonsystematic risk, and explain why investors are compensated for bearing systematic risk but receive no compensation for bearing nonsystematic risk. We discuss in detail the CAPM, which is a simple model for estimating asset returns based only on the asset’s systematic risk. Finally, we illustrate how the CAPM allows security selection to build an optimal portfolio for an investor by changing the asset mix beyond a passive market portfolio.

The reading is organized as follows. In Section 2, we discuss the consequences of combining a risk-free asset with the market portfolio and provide an interpretation of the capital market line. Section 3 decomposes total risk into systematic and nonsystematic risk and discusses the characteristics of and differences between the two kinds of risk. We also introduce return-generating models, including the single-index model, and illustrate the calculation of beta by using formulas and graphically by using the security characteristic line. In Section 4, we introduce the capital asset pricing model and the security market line. We discuss many applications of the CAPM and the SML throughout the reading, including the use of expected return in making capital budgeting decisions, the evaluation of portfolios using the CAPM’s risk-adjusted return as the benchmark, security selection, and determining whether adding a new security to the current portfolio is appropriate. Our focus on the CAPM does not suggest that the CAPM is the only viable asset pricing model. Although the CAPM is an excellent starting point, more advanced readings expand on these discussions and extend the analysis to other models that account for multiple explanatory factors. A preview of a number of these models is given in Section 5, and a summary and practice problems conclude the reading.

It is important to understand how prices of derivatives are determined. Whether one is on the buy side or the sell side, a solid understanding of pricing financial products is critical to effective investment decision making. After all, one can hardly determine what to offer or bid for a financial product, or any product for that matter, if one has no idea how its characteristics combine to create value.

Understanding the pricing of financial assets is important. Discounted cash flow methods and models, such as the capital asset pricing model and its variations, are useful for determining the prices of financial assets. The unique characteristics of derivatives, however, pose some complexities not associated with assets, such as equities and fixed-income instruments. Somewhat surprisingly, however, derivatives also have some simplifying characteristics. For example, as we will see in this reading, in well-functioning derivatives markets the need to determine risk premiums is obviated by the ability to construct a risk-free hedge. Correspondingly, the need to determine an investor’s risk aversion is irrelevant for derivative pricing, although it is certainly relevant for pricing the underlying.

The purpose of this reading is to establish the foundations of derivative pricing on a basic conceptual level. The following topics are covered:

• How does the pricing of the underlying asset affect the pricing of derivatives?

• How are derivatives priced using the principle of arbitrage?

• How are the prices and values of forward contracts determined?

• How are futures contracts priced differently from forward contracts?

• How are the prices and values of swaps determined?

• How are the prices and values of European options determined?

• How does American option pricing differ from European option pricing?

This reading is organized as follows. Section 2 explores two related topics, the pricing of the underlying assets on which derivatives are created and the principle of arbitrage. Section 3 describes the pricing and valuation of forwards, futures, and swaps. Section 4 introduces the pricing and valuation of options. Section 5 provides a summary.

Assets under management in vehicles classified as alternative investments have grown rapidly since the mid-1990s. This growth has largely occurred because of interest in these investments by institutions, such as endowment and pension funds, as well as high-net-worth individuals seeking diversification and return opportunities. Alternative investments are perceived to behave differently from traditional investments. Investors may seek either absolute return or relative return.

Some investors hope alternative investments will provide positive returns throughout the economic cycle; this goal is an absolute return objective. Alternative investments are not free of risk, however, and their returns may be negative and/or correlated with other investments, including traditional investments, especially in periods of financial crisis. Some investors in alternative investments have a relative return objective. A relative return objective, which is often the objective of portfolios of traditional investment, seeks to achieve a return relative to an equity or fixed-income benchmark.

This reading is organized as follows. Section 2 describes alternative investments’ basic characteristics and categories; general strategies of alternative investment portfolio managers; the role of alternative investments in a diversified portfolio; and investment structures used to provide access to alternative investments. Sections 3 through 7 describe features of hedge funds, private equity, real estate, commodities, and infrastructure, respectively, along with issues in calculating returns to and valuation of each.1 Section 8 briefly describes other alternative investments. Section 9 provides an overview of risk management, including due diligence, of alternative investments. A summary and practice problems conclude the reading.

The GIPS standards are a practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for investment firms to follow in calculating and presenting their historical investment results to prospective clients. The GIPS standards ensure fair representation and full disclosure of investment performance. In other words, the GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.

The reading is organized as follows:

Section 2 introduces some terminology used throughout the reading and supplies some economic intuition for the variables we will discuss.

Section 3 tackles the problem of determining the worth at a future point in time of an amount invested today.

Section 4 addresses the future worth of a series of cash flows. These two sections provide the tools for calculating the equivalent value at a future date of a single cash flow or series of cash flows.

Sections 5 and 6 discuss the equivalent value today of a single future cash flow and a series of future cash flows, respectively.

In Section 7, we explore how to determine other quantities of interest in time value of money problems.

Section 2 introduces the analysis of market structures. The section addresses questions such as:

• What determines the degree of competition associated with each market structure?
• Given the degree of competition associated with each market structure, what decisions are left to the management team developing corporate strategy?
• How does a chosen pricing and output strategy evolve into specific decisions that affect the profitability of the firm? The answers to these questions are related to the forces of the market structure within which the firm operates.

Sections 3, 4, 5, and 6 analyze demand, supply, optimal price and output, and factors affecting long-run equilibrium for perfect competition, monopolistic competition, oligopoly, and pure monopoly, respectively.

Section 7 reviews techniques for identifying the various forms of market structure. For example, there are accepted measures of market concentration that are used by regulators of financial institutions to judge whether or not a planned merger or acquisition will harm the competitive nature of regional banking markets. Financial analysts should be able to identify the type of market structure a firm is operating within. Each different structure implies a different long-run sustainability of profits.

This reading is organized as follows:

Section 2 describes the business cycle and its phases. The typical behaviors of businesses and households in different phases and transitions between phases are described.

Section 3 provides an introduction to business cycle theory, in particular how different economic schools of thought interpret the business cycle and their recommendations with respect to it.

Section 4 introduces basic concepts concerning unemployment and inflation, two measures of short-term economic activity that are important to economic policymakers.

Section 5 discusses variables that demonstrate predictable relationships with the economy, focusing on variables whose movements have value in predicting the future course of the economy.

The income statement presents information on the financial results of a company’s business activities over a period of time. The income statement communicates how much revenue the company generated during a period and what costs it incurred in connection with generating that revenue. The basic equation underlying the income statement, ignoring gains and losses, is Revenue minus Expenses equals Net income. The income statement is also sometimes referred to as the “statement of operations,” “statement of earnings,” or “profit and loss (P&L) statement.”

Under IFRS, the income statement may be presented as a separate statement followed by a statement of comprehensive income that begins with the profit or loss from the income statement or as a section of a single statement of comprehensive income. US GAAP permit the same alternative presentation formats.2 This reading focuses on the income statement, but also discusses comprehensive income (profit or loss from the income statement plus other comprehensive income).

Investment analysts intensely scrutinize companies’ income statements.3 Equity analysts are interested in them because equity markets often reward relatively high- or low-earnings growth companies with above-average or below-average valuations, respectively, and because inputs into valuation models often include estimates of earnings. Fixed-income analysts examine the components of income statements, past and projected, for information on companies’ abilities to make promised payments on their debt over the course of the business cycle. Corporate financial announcements frequently emphasize information reported in income statements, particularly earnings, more than information reported in the other financial statements.

Financial analysis tools can be useful in assessing a company’s performance and trends in that performance. In essence, an analyst converts data into financial metrics that assist in decision making. Analysts seek to answer such questions as:

How successfully has the company performed, relative to its own past performance and relative to its competitors?

How is the company likely to perform in the future?

Based on expectations about future performance, what is the value of this company or the securities it issues?

A primary source of data is a company’s annual report, including the financial statements and notes, and management commentary (operating and financial review or management’s discussion and analysis). This reading focuses on data presented in financial reports prepared under IFRS and US GAAP. However, financial reports do not contain all the information needed to perform effective financial analysis. Although financial statements do contain data about the past performance of a company (its income and cash flows) as well as its current financial condition (assets, liabilities, and owners’ equity), such statements do not necessarily provide all the information useful for analysis nor do they forecast future results. The financial analyst must be capable of using financial statements in conjunction with other information to make projections and reach valid conclusions. Accordingly, an analyst typically needs to supplement the information found in a company’s financial reports with other information, including information on the economy, industry, comparable companies, and the company itself.

This reading describes various techniques used to analyze a company’s financial statements. Financial analysis of a company may be performed for a variety of reasons, such as valuing equity securities, assessing credit risk, conducting due diligence related to an acquisition, or assessing a subsidiary’s performance. This reading will describe techniques common to any financial analysis and then discuss more specific aspects for the two most common categories: equity analysis and credit analysis.

Equity analysis incorporates an owner’s perspective, either for valuation or performance evaluation. Credit analysis incorporates a creditor’s (such as a banker or bondholder) perspective. In either case, there is a need to gather and analyze information to make a decision (ownership or credit); the focus of analysis varies because of the differing interest of owners and creditors. Both equity and credit analyses assess the entity’s ability to generate and grow earnings, and cash flow, as well as any associated risks. Equity analysis usually places a greater emphasis on growth, whereas credit analysis usually places a greater emphasis on risks. The difference in emphasis reflects the different fundamentals of these types of investments: The value of a company’s equity generally increases as the company’s earnings and cash flow increase, whereas the value of a company’s debt has an upper limit.

Ideally, analysts would always have access to financial reports that are based on sound financial reporting standards, such as those from the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), and are free from manipulation. But, in practice, the quality of financial reports can vary greatly. High-quality financial reporting provides information that is useful to analysts in assessing a company’s performance and prospects. Low-quality financial reporting contains inaccurate, misleading, or incomplete information.

Extreme lapses in financial reporting quality have given rise to high-profile scandals that resulted not only in investor losses but also in reduced confidence in the financial system. Financial statement users who were able to accurately assess financial reporting quality were better positioned to avoid losses. These lapses illustrate the challenges analysts face as well as the potential costs of failing to recognize practices that result in misleading or inaccurate financial reports.1Examples of misreporting can provide an analyst with insight into various signals that may indicate poor-quality financial reports.

It is important to be aware, however, that high-profile financial scandals reflect only those instances of misreporting that were identified. Although no one can know the extent of undetected misreporting, some research suggests that it is relatively widespread. An Ernst & Young 2013 survey of more than 3,000 board members, executives, managers, and other employees in 36 countries across Europe, the Middle East, India, and Africa indicates that 20% of the respondents had seen manipulation (such as overstated sales and understated costs) occurring in their own companies, and 42% of board directors and senior managers were aware of some type of irregular financial reporting in their own companies (Ernst & Young, 2013). Another survey of 169 chief financial officers of public US companies found that they believed, on average, that “in any given period, about 20% of companies manage earnings to misrepresent economic performance, and for such companies 10% of EPS [earnings per share] is typically managed” (Dichev, Graham, Harvey, and Rajgopal, 2013).

This reading addresses financial reporting quality, which pertains to the quality of information in financial reports, including disclosures in notes. High-quality reporting provides decision-useful information, which is relevant and faithfully represents the economic reality of the company’s activities during the reporting period as well as the company’s financial condition at the end of the period. A separate but interrelated attribute of quality is quality of reported results or earnings quality, which pertains to the earnings and cash generated by the company’s actual economic activities and the resulting financial condition. The term “earnings quality” is commonly used in practice and will be used broadly to encompass the quality of earnings, cash flow, and/or balance sheet items. High-quality earnings result from activities that a company will likely be able to sustain in the future and provide a sufficient return on the company’s investment. The concepts of earnings quality and financial reporting quality are interrelated because a correct assessment of earnings quality is possible only when there is some basic level of financial reporting quality. Beyond this basic level, as the quality of reporting increases, the ability of financial statement users to correctly assess earnings quality and to develop expectations for future performance arguably also increases.

Section 2 provides a conceptual overview of reporting quality.

Section 3 discusses motivations that might cause, and conditions that might enable, management to issue financial reports that are not high quality and mechanisms that aim to provide discipline to financial reporting quality.

Section 4 describes choices made by management that can affect financial reporting quality—presentation choices, accounting methods, and estimates—as well as warning signs of poor-quality financial reporting.

This reading presents several important applications of financial statement analysis. Among the issues we will address are the following:

• What are the key questions to address in evaluating a company’s past financial performance?

• How can an analyst approach forecasting a company’s future net income and cash flow?

• How can financial statement analysis be used to evaluate the credit quality of a potential fixed-income investment?

• How can financial statement analysis be used to screen for potential equity investments?

• How can differences in accounting methods affect financial ratio comparisons between companies, and what are some adjustments analysts make to reported financials to facilitate comparability among companies.

The reading “Financial Statement Analysis: An Introduction” described a framework for conducting financial statement analysis. Consistent with that framework, prior to undertaking any analysis, an analyst should explore the purpose and context of the analysis. The purpose and context guide further decisions about the approach, the tools, the data sources, and the format in which to report results of the analysis, and also suggest which aspects of the analysis are most important. Having identified the purpose and context, the analyst should then be able to formulate the key questions that the analysis must address. The questions will suggest the data the analyst needs to collect to objectively address the questions. The analyst then processes and analyzes the data to answer these questions. Conclusions and decisions based on the analysis are communicated in a format appropriate to the context, and follow-up is undertaken as required. Although this reading will not formally present applications as a series of steps, the process just described is generally applicable.

Section 2 of this reading describes the use of financial statement analysis to evaluate a company’s past financial performance.

Section 3 describes basic approaches to projecting a company’s future financial performance.

Section 4 presents the use of financial statement analysis in assessing the credit quality of a potential debt investment.

Section 5 concludes the survey of applications by describing the use of financial statement analysis in screening for potential equity investments. Analysts often encounter situations in which they must make adjustments to a company’s reported financial results to increase their accuracy or comparability with the financials of other companies.

Section 6 illustrates several common types of analyst adjustments.

Section 7 presents a summary.

This reading presents elementary topics in leverage. Leverage is the use of fixed costs in a company’s cost structure. Fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.

Analysts refer to the use of fixed costs as leverage because fixed costs act as a fulcrum for the company’s earnings. Leverage can magnify earnings both up and down. The profits of highly leveraged companies might soar with small upturns in revenue. But the reverse is also true: Small downturns in revenue may lead to losses.

Analysts need to understand a company’s use of leverage for three main reasons. First, the degree of leverage is an important component in assessing a company’s risk and return characteristics. Second, analysts may be able to discern information about a company’s business and future prospects from management’s decisions about the use of operating and financial leverage. Knowing how to interpret these signals also helps the analyst evaluate the quality of management’s decisions. Third, the valuation of a company requires forecasting future cash flows and assessing the risk associated with those cash flows. Understanding a company’s use of leverage should help in forecasting cash flows and in selecting an appropriate discount rate for finding their present value.

The reading is organized as follows:

Section 2 introduces leverage and defines important terms.

Section 3 illustrates and discusses measures of operating leverage and financial leverage, which combine to define a measure of total leverage that gauges the sensitivity of net income to a given percent change in units sold. This section also covers breakeven points in using leverage and corporate reorganization (a possible consequence of using leverage inappropriately).

This reading will focus on economic and financial risk as it relates to investment management.

All businesses and investors manage risk in the choices they make, even if not conciously. Business and investing are about allocating resources and capital to chosen risks. In their decision process, businesses and investors may take steps to avoid some risks, pursue the risks that provide the highest rewards, and measure and mitigate their exposure to these risks as necessary. Risk management processes and tools make difficult business and financial problems easier to address. Risk is not just a matter of fate; it can be actively controled with decisions, within a risk management framework. Risk is an integral part of the business or investment process. Even in the earliest models of modern portfolio theory, such as mean–variance portfolio optimization and the capital asset pricing model, investment return is linked directly to risk but requires that risk be managed optimally. Proper identification and measurement of risk, and keeping risks aligned with the goals of the enterprise, are key factors in managing businesses and investments. Good risk management results in a higher chance of a preferred outcome—more value for the company or portfolio or more utility for the individual.

Portfolio managers need to be familiar with risk management not only to improve the portfolio’s risk–return outcome, but also because of two other ways in which they use risk management at an enterprise level. First, they help to manage their own companies that have their own enterprise risk issues. Second, many portfolio assets are claims on companies that have risks. Portfolio managers need to evaluate the companies’ risks and how those companies are addressing them.

This reading takes talks about the risk management of enterprises in general and portfolio risk management. The principles underlying portfolio risk management are generally applicable to the risk management of financial and non-financial institutions as well.

The concept of risk management applies to individuals. Although many large entities formally practice risk management, most individuals practice it informally and disorderly, oftentimes responding to risk events after they occur, and they ignore more subtle risks often. Many individuals simply do not view risk management as a formal, systematic process that would help them achieve not only their financial goals but also the ultimate end result of happiness, or maximum utility as economists like to call it, but they should.

Although the primary focus of this reading is on institutions, we will also cover risk management as it applies to individuals. We will show that many common themes underlie risk management—themes that are applicable to both organizations and individuals.

Although often viewed as defensive, risk management is a valuable offensive weapon in the manager’s arsenal. In the quest for preferred outcomes, such as higher profit, returns, or share price, management does not usually get to choose the outcomes but does choose the risks it takes in pursuit of those outcomes. The choice of which risks to undertake through the allocation of its scarce resources is the key tool available to management. An organization with a comprehensive risk management culture in place, in which risk is integral to every key strategy and decision, should perform better in the long-term, in good times and bad, as a result of better decision making.

The fact that all businesses and investors engage in risky activities (i.e., activities with uncertain outcomes) raises a number of important questions. The questions that this reading will address include the following:

• What is risk management, and why is it important?

• What risks does an organization (or individual) face in pursuing its objectives?

• How are an entity’s goals affected by ri

...

• What is risk management, and why is it important?

• What risks does an organization (or individual) face in pursuing its objectives?

• How are an entity’s goals affected by risk, and how does it make risk management decisions to produce better results?

• How does risk governance guide the risk management process and risk budgeting to integrate an organization’s goals with its activities?

• How does an organization measure and evaluate the risks it faces, and what tools does it have to address these risks?

The answers to these questions collectively help to define the process of risk management.

This reading is organized along the lines of these questions.

Section 2 describes the risk management process.

Section 3 discusses risk governance and risk tolerance.

Section 4 covers the identification of various risks.

Section 5 addresses the measurement and management of risks.

Section 6 provides a summary.

Our objective in this reading is to identify the optimal risky portfolio for all investors by using the capital asset pricing model (CAPM). The foundation of this reading is the computation of risk and return of a portfolio and the role that correlation plays in diversifying portfolio risk and arriving at the efficient frontier. The efficient frontier and the capital allocation line consist of portfolios that are generally acceptable to all investors. By combining an investor’s individual indifference curves with the market-determined capital allocation line, we are able to illustrate that the only optimal risky portfolio for an investor is the portfolio of all risky assets (i.e., the market).

Additionally, we discuss the capital market line, a special case of the capital allocation line that is used for passive investor portfolios. We also differentiate between systematic and nonsystematic risk, and explain why investors are compensated for bearing systematic risk but receive no compensation for bearing nonsystematic risk. We discuss in detail the CAPM, which is a simple model for estimating asset returns based only on the asset’s systematic risk. Finally, we illustrate how the CAPM allows security selection to build an optimal portfolio for an investor by changing the asset mix beyond a passive market portfolio.

The reading is organized as follows:

In Section 2, we discuss the consequences of combining a risk-free asset with the market portfolio and provide an interpretation of the capital market line.

Section 3 decomposes total risk into systematic and nonsystematic risk and discusses the characteristics of and differences between the two kinds of risk. We also introduce return-generating models, including the single-index model, and illustrate the calculation of beta by using formulas and graphically by using the security characteristic line.

In Section 4, we introduce the capital asset pricing model and the security market line. We discuss many applications of the CAPM and the SML throughout the reading, including the use of expected return in making capital budgeting decisions, the evaluation of portfolios using the CAPM’s risk-adjusted return as the benchmark, security selection, and determining whether adding a new security to the current portfolio is appropriate.

in Section 5 a preview of a number of models is given. Our focus on the CAPM does not suggest that the CAPM is the only viable asset pricing model. Although the CAPM is an excellent starting point, more advanced readings expand on these discussions and extend the analysis to other models that account for multiple explanatory factors.

It is useful to distinguish between stationary and nonstationary sequential dis- tributions. In the stationary case, the data evolves in time, but the distribution from which it is generated remains the same.

Although such models are tractable, they are also severely limited. We can ob- tain a more general framework, while still retaining tractability, by the introduction of latent variables, leading to state space models.

Here we focus on the two most important examples of state space models, namely the hidden Markov model, in which the latent variables are discrete, and linear dynamical systems, in which the latent variables are Gaussian. Both models are described by directed graphs having a tree structure (no loops) for which inference can be performed efficiently using the sum-product algorithm

It is always important to remember with fancy indexing that the return value reflects the broadcasted shape of the indices, rather than the shape of the array being indexed

In most applications of such (Markovian) models, the conditional distributions \(p(x_n |x_{n−1} ) \) that define the model will be constrained to be equal, corresponding to the assumption of a stationary time series. The model is then known as a homogeneous Markov chain.

Because the latent variables are K-dimensional binary variables, this conditional distribution corresponds to a table of numbers that we denote by A, the elements of which are known as transition probabilities.

the conditional distributions of the observed variables is \(p(x_n \mid z_n , \phi) \), where φ is a set of parameters governing the distribution. These are known as emission probabilities

It is important to understand how prices of derivatives are determined. Whether one is on the buy side or the sell side, a solid understanding of pricing financial products is critical to effective investment decision making. After all, one can hardly determine what to offer or bid for a financial product, or any product for that matter, if one has no idea how its characteristics combine to create value.

Understanding the pricing of financial assets is important. Discounted cash flow methods and models, such as the capital asset pricing model and its variations, are useful for determining the prices of financial assets. The unique characteristics of derivatives, however, pose some complexities not associated with assets, such as equities and fixed-income instruments. Somewhat surprisingly, however, derivatives also have some simplifying characteristics. For example, as we will see in this reading, in well-functioning derivatives markets the need to determine risk premiums is obviated by the ability to construct a risk-free hedge. Correspondingly, the need to determine an investor’s risk aversion is irrelevant for derivative pricing, although it is certainly relevant for pricing the underlying.

The purpose of this reading is to establish the foundations of derivative pricing on a basic conceptual level. The following topics are covered:

• How does the pricing of the underlying asset affect the pricing of derivatives?

• How are derivatives priced using the principle of arbitrage?

• How are the prices and values of forward contracts determined?

• How are futures contracts priced differently from forward contracts?

• How are the prices and values of swaps determined?

• How are the prices and values of European options determined?

• How does American option pricing differ from European option pricing?

This reading is organized as follows:

Section 2 explores two related topics, the pricing of the underlying assets on which derivatives are created and the principle of arbitrage.

Section 3 describes the pricing and valuation of forwards, futures, and swaps.

Section 4 introduces the pricing and valuation of options.

Section 5 provides a summary.

Assets under management in vehicles classified as alternative investments have grown rapidly since the mid-1990s. This growth has largely occurred because of interest in these investments by institutions, such as endowment and pension funds, as well as high-net-worth individuals seeking diversification and return opportunities. Alternative investments are perceived to behave differently from traditional investments. Investors may seek either absolute return or relative return.

Some investors hope alternative investments will provide positive returns throughout the economic cycle; this goal is an absolute return objective. Alternative investments are not free of risk, however, and their returns may be negative and/or correlated with other investments, including traditional investments, especially in periods of financial crisis. Some investors in alternative investments have a relative return objective. A relative return objective, which is often the objective of portfolios of traditional investment, seeks to achieve a return relative to an equity or fixed-income benchmark.

This reading is organized as follows:

Section 2 describes alternative investments’ basic characteristics and categories; general strategies of alternative investment portfolio managers; the role of alternative investments in a diversified portfolio; and investment structures used to provide access to alternative investments.

Sections 3 through 7 describe features of hedge funds, private equity, real estate, commodities, and infrastructure, respectively, along with issues in calculating returns to and valuation of each.

Section 8 briefly describes other alternative investments.

Section 9 provides an overview of risk management, including due diligence, of alternative investments.

The GIPS standards lead investment management firms to avoid misrepresentations of performance and to communicate all relevant information that prospective clients should know in order to evaluate past results.

The GIPS standards are a practitioner-driven set of ethical principles that establish a standardized, industry-wide approach for investment firms to follow in calculating and presenting their historical investment results to prospective clients. The GIPS standards ensure fair representation and full disclosure of investment performance.

The reading is organized as follows:

Sección 2 discute las caracteristicas de inversión de activos. Particularmente, enseñamos los varios tipos de riesgo y retorno, como se calculan y como se aplican a la seleccion apropiada de activos para incluir en el portafolios.

Section 3 habla de la aversión al riesgo y como las curvas de indiferencia pueden ser construidas. Las curvas de indiferencia son entonces aplicadas a la selección de un portafolios optimo usando dos activos riesgosos.

Section 4 provee un entendimiento y manera de calcular el riesgo del portafolios. El rol de la correlación y la diversificación de riesgo en el portafolios son examinados a detalle.

Section 5 comienza con los activos de riesgo disponibles para los inversionistas y construye muchos portafolios de riesgo. Ilustra el proceso de acotar las opciones a un set eficiente de portafolios de riesgo antes de identificar el portafolio de riesgo optimo. El portafolio de riesgo es combinado con las preferencias del inversionista para generar el portafolio de riesgo optimo.

The scope of working capital management includes transactions, relations, analyses, and focus:

• Transactions include payments for trade, financing, and investment.

• Relations with financial institutions and trading partners must be maintained to ensure that the transactions work effectively.

• Analyses of working capital management activities are required so that appropriate strategies can be formulated and implemented.

• Focus requires that organizations of all sizes today must have a global viewpoint with strong emphasis on liquidity.

Both internal and external factors influence working capital needs; we summarize them in Exhibit 1.

Exhibit 1. Internal and External Factors That Affect Working Capital Needs

Internal Factors (Bill Cosby)	External Factors
Company size and growth rates Organizational structure Sophistication of working capital management Borrowing and investing positions/activities/capacities	Banking services Interest rates New technologies and new products The economy Competitors

La lectura se estructura así:

Section 2 discute la declaración de política de inversión, un documento escrito que captura los objetivos y restricciones de inversión del cliente

Section 3 discute el proceso de construcción del portafolio, incluyendo el primer paso de especificar una asignación estratégica de activos para el cliente.

Demand-pull inflation

Cost – Push Inflation

CPI is the cost of living index popularly known as Core Inflation

They differ in terms of their weighting pattern. First, food has a larger weight in CPIs - ranging from 46 per cent in CPI-IW to 69 per cent in CPI-AL, whereas it has a weight of only 27 per cent in the WPI. The CPIs are, therefore, more sensitive to changes in prices of food items.

Derivatives are financial instruments that derive their value from an 'underlying

The difference between the price of the underlying asset in the spot market and the futures market is called 'Basis'. (As 'spot market' is a market for immediate delivery

In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income, and is rooted in microeconomics , which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics.

Microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and the theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms.

It is expected that candidates will be familiar with the basic concepts of demand and supply. This material is covered in detail in the recommended prerequisite readings.

In this reading, we will explore how buyers and sellers interact to determine transaction prices and quantities.

The reading is organized as follows:

Section 2 discusses the consumer or demand side of the market model.

Section 3 discusses the supply side of the consumer goods market, paying particular attention to the firm’s costs.

Section 4 provides a summary of key points in the reading.

In the field of economics, microeconomics is the study of the economic activity and behavior of individual economic units, such as a household, a company, or a market for a particular good or service, and macroeconomics is the study of the aggregate activities of households, companies, and markets. Macroeconomics focuses on national aggregates, such as total investment, the amount spent by all businesses on plant and equipment; total consumption, the amount spent by all households on goods and services; the rate of change in the general level of prices; and the overall level of interest rates.

Macroeconomic analysis examines a nation’s aggregate output and income, its competitive and comparative advantages, the productivity of its labor force, its price level and inflation rate, and the actions of its national government and central bank. The objective of macroeconomic analysis is to address such fundamental questions as:

• What is an economy’s aggregate output, and how is aggregate income measured?

• What factors determine the level of aggregate output/income for an economy?

• What are the levels of aggregate demand and aggregate supply of goods and services within the country?

• Is the level of output increasing or decreasing, and at what rate?

• Is the general price level stable, rising, or falling?

• Is unemployment rising or falling?

• Are households spending or saving more?

• Are workers able to produce more output for a given level of inputs?

• Are businesses investing in and expanding their productive capacity?

• Are exports (imports) rising or falling?

From an investment perspective, investors must be able to evaluate a country’s current economic environment and to forecast its future economic environment in order to identify asset classes and securities that will benefit from economic trends occurring within that country. Macroeconomic variables—such as the level of inflation, unemployment, consumption, government spending, and investment—affect the overall level of activity within a country. They also have different impacts on the growth and profitability of industries within a country, the companies within those industries, and the returns of the securities issued by those companies.

This reading is organized as follows:

Section 2 describes gross domestic product and related measures of domestic output and income.

Section 3 discusses short-run and long-run aggregate demand and supply curves, the causes of shifts and movements along those curves, and factors that affect equilibrium levels of output, prices, and interest rates.

Section 4 discusses sources, sustainability, and measures of economic growth.

Global investors must address two fundamentally interrelated questions: where to invest and in what asset classes? Some countries may be attractive from an equity perspective because of their strong economic growth and the profitability of particular domestic sectors or industries. Other countries may be attractive from a fixed income perspective because of their interest rate environment and price stability. To identify markets that are expected to provide attractive investment opportunities, investors must analyze cross-country differences in such factors as expected GDP growth rates, monetary and fiscal policies, trade policies, and competitiveness. From a longer term perspective investors also need to consider such factors as a country’s stage of economic and financial market development, demographics, quality and quantity of physical and human capital (accumulated education and training of workers), and its area(s) of comparative advantage.1

This reading provides a framework for analyzing a country’s trade and capital flows and their economic implications. International trade can facilitate economic growth by increasing the efficiency of resource allocation, providing access to larger capital and product markets, and facilitating specialization based on comparative advantage. The flow of financial capital (funds available for investment) between countries with excess savings and those where financial capital is scarce can increase liquidity, raise output, and lower the cost of capital. From an investment perspective, it is important to understand the complex and dynamic nature of international trade and capital flows because investment opportunities are increasingly exposed to the forces of global competition for markets, capital, and ideas.

This reading is organized as follows:

Section 2 defines basic terminology used in the reading and describes patterns and trends in international trade and capital flows. It also discusses the benefits of international trade, distinguishes between absolute and comparative advantage, and explains two traditional models of comparative advantage.

Section 3 describes trade restrictions and their implications and discusses the motivation for, and advantages of, trade agreements.

Section 4 describes the balance of payments.

Section 5 discusses the function and objectives of international organizations that facilitate trade.

Financial reporting standards provide principles for preparing financial reports and determine the types and amounts of information that must be provided to users of financial statements, including investors and creditors, so that they may make informed decisions. This reading focuses on the framework within which these standards are created. An understanding of the underlying framework of financial reporting standards, which is broader than knowledge of specific accounting rules, will allow an analyst to assess the valuation implications of financial statement elements and transactions—including transactions, such as those that represent new developments, which are not specifically addressed by the standards.

The reading is organized as follows:

Section 2 of this reading discusses the objective of financial statements and the importance of financial reporting standards in security analysis and valuation.

Section 3 describes the roles of financial reporting standard-setting bodies and regulatory authorities and several of the financial reporting standard-setting bodies and regulatory authorities.

Section 4 describes the trend toward and barriers to convergence of global financial reporting standards.

Section 5 describes the IFRS framework and general requirements for financial statements.

Section 6 discusses the characteristics of an effective financial reporting framework along with some of the barriers to a single coherent framework.

Section 7 illustrates some of the specific differences between IFRS and US GAAP.

Section 8 discusses the importance of monitoring developments in financial reporting standards.

Merchandising and manufacturing companies generate revenues and profits through the sale of inventory. Further, inventory may represent a significant asset on these companies’ balance sheets. Merchandisers (wholesalers and retailers) purchase inventory, ready for sale, from manufacturers and thus account for only one type of inventory—finished goods inventory. Manufacturers, however, purchase raw materials from suppliers and then add value by transforming the raw materials into finished goods. They typically classify inventory into three different categories: raw materials, work in progress, and finished goods. Work-in-progress inventories have started the conversion process from raw materials but are not yet finished goods ready for sale. Manufacturers may report either the separate carrying amounts of their raw materials, work-in-progress, and finished goods inventories on the balance sheet or simply the total inventory amount. If the latter approach is used, the company must then disclose the carrying amounts of its raw materials, work-in-progress, and finished goods inventories in a footnote to the financial statements.

Inventories and cost of sales (cost of goods sold) are significant items in the financial statements of many companies. Comparing the performance of these companies is challenging because of the allowable choices for valuing inventories: Differences in the choice of inventory valuation method can result in significantly different amounts being assigned to inventory and cost of sales. Financial statement analysis would be much easier if all companies used the same inventory valuation method or if inventory price levels remained constant over time. If there was no inflation or deflation with respect to inventory costs and thus unit costs were unchanged, the choice of inventory valuation method would be irrelevant. However, inventory price levels typically do change over time.

IFRS permit the assignment of inventory costs (costs of goods available for sale) to inventories and cost of sales by three cost formulas: specific identification, first-in, first-out (FIFO), and weighted average cost. US GAAP allow the same three inventory valuation methods, referred to as cost flow assumptions in US GAAP, but also include a fourth method called last-in, first-out (LIFO). The choice of inventory valuation method affects the allocation of the cost of goods available for sale to ending inventory and cost of sales. Analysts must understand the various inventory valuation methods and the related impact on financial statements and financial ratios in order to evaluate a company’s performance over time and relative to industry peers. The company’s financial statements and related notes provide important information that the analyst can use in assessing the impact of the choice of inventory valuation method on financial statements and financial ratios.

This reading is organized as follows:

Section 2 discusses the costs that are included in inventory and the costs that are recognised as expenses in the period in which they are incurred.

Section 3 describes inventory valuation methods and compares the measurement of ending inventory, cost of sales and gross profit under each method, and when using periodic versus perpetual inventory systems.

Section 4 describes the LIFO method, LIFO reserve, and effects of LIFO liquidations, and demonstrates the adjustments required to compare a company that uses LIFO with one that uses FIFO.

Section 5 describes the financial statement effects of a change in inventory valuation method.

Section 6 discusses the measurement and reporting of inventory when its value changes.

Section 7 describes the presentation of inventories on the financial statements and related disclosures, discusses inventory ratios and their interpretation, and shows examples of financial analysis with respect to inventories.

Long-lived assets , also referred to as non-current assets or long-term assets, are assets that are expected to provide economic benefits over a future period of time, typically greater than one year.1 Long-lived assets may be tangible, intangible, or financial assets. Examples of long-lived tangible assets, typically referred to as property, plant, and equipment and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles; examples of long-lived intangible assets (assets lacking physical substance) include patents and trademarks; and examples of long-lived financial assets include investments in equity or debt securities issued by other companies. The scope of this reading is limited to long-lived tangible and intangible assets (hereafter, referred to for simplicity as long-lived assets).

The first issue in accounting for a long-lived asset is determining its cost at acquisition. The second issue is how to allocate the cost to expense over time. The costs of most long-lived assets are capitalised and then allocated as expenses in the profit or loss (income) statement over the period of time during which they are expected to provide economic benefits. The two main types of long-lived assets with costs that are typically not allocated over time are land, which is not depreciated, and those intangible assets with indefinite useful lives. Additional issues that arise are the treatment of subsequent costs incurred related to the asset, the use of the cost model versus the revaluation model, unexpected declines in the value of the asset, classification of the asset with respect to intent (for example, held for use or held for sale), and the derecognition of the asset.

This reading is organised as follows:

Section 2 describes and illustrates accounting for the acquisition of long-lived assets, with particular attention to the impact of capitalizing versus expensing expenditures.

Section 3 describes the allocation of the costs of long-lived assets over their useful lives.

Section 4 discusses the revaluation model that is based on changes in the fair value of an asset.

Section 5 covers the concepts of impairment (unexpected decline in the value of an asset).

Section 6 describes accounting for the derecognition of long-lived assets.

Section 7 describes financial statement presentation, disclosures, and analysis of long-lived assets.

Section 8 discusses differences in financial reporting of investment property compared with property, plant, and equipment.

Section 9 describes accounting for leases.