Miller Modiliagni

Miller and Modiliagni were two great economists that contributed in a big way in the finance field, both winning Nobel prizes in their day.

Today, the MM proposition 1 that states that under the following assumptions the capital structure is irrelevant to the value of the firm is a framework used by CFOs and companies around the world.

The assumptions under this framework are as follows and can in turn be relaxed to evaluate specific corporate situations and decisions:

1. Perfect and Complete Capital Markets

2. NO Taxes

3. Bankruptcy is NOT costly

4. Capital Structure does NOT affect investment policy and cash flows

5. Symmetric Information (no one has an informational advantage)


Their second proposition is also very powerful and states that the cost of equity increases linearly with the market-value based D/E ration

Two Interesting Behavioral Points of Advice

If you want to know what someone thinks about something, ask what they think others think about this subject.

If you don't want to say what your salary expectations are, just say you heard from a friend that typically for this type of job the salary is so and so.

Some Terminology Related to International Trade

Bill of Exchange - a document used in international trade to pay for goods or services. It is signed by the person promising to pay. The bill of exchange may be payable on demand or at a point in time in the future.

A bill of exchange may be transferable and is similar to a promissory note.

Letter of Credit - this is a letter from a bank guaranteeing the buyers payment will be honored as per the relevant contract. In the event the buyer is not able to make the relevant payment, the bank will be required to pay the remaining outstanding amount due.

In international trade, parties may not know each other and a letter of credit can provide the necessary comfort to the seller that it will receive prompt payment.

Letters of credit are typically negotiable which means they can normally be freely transferable to third parties. 

Financing Options Alternatives to Equity Financing

Overdraft - a form of lending where the bank grants a limit facility and the customer can take advantage of it as necessary. Essentially this is a form of unsecured short term financing. 

Advantages:

1. Typically cheaper than most sources of financing 

2. Interest is payable only on the amounts actually drawn which creates flexibility for the borrower and helps reduce costs. (especially for companies with fluctuating demand for WC) 

Disadvantages:

1. Overdrafts are typically payable on demand which increases the financial risk for the business

2. Longer-term overdrafts may be included in gearing ratios and banks could request security

Debt Factoring - an arrangement where the factor company advances a portion of the A/R to be collected and undertakes the admin functions of collecting the receivables

Advantages:

1. The factor company takes over client invoicing, sales accounting and debt collection and thereby  the client can reduce its own costs on the P&L

2. In certain circumstances the factor company will take over the risk of loss on the receivables, resulting in a transfer of credit risk on the A/R from the corporate to the factor company

3. Frees up capital that can be used to finance growth

4. Focus management time 

Disadvantages:

1. The level of finance is geared to sales volumes. Factoring does not resolve the WC requirements to finance growth since A/R always lag sales volume growth

2. Tends to be expensive relative to bank financing. Typically 2% of invoice value for service charges + bank rates for financing. 

3. May affect reputation with clients especially when clients pay directly to the factor company giving the impression that the company is facing financial troubles. 

Invoice Discounting - in this case a selected portion of the A/R is sold to a buyer at a discount. The Buyer does not undertake any administration of the client's sales ledger. 

1. Allows to raise capital from the A/R 

2. No security required. 

Disadvantages 

1. More expensive than any other source of financing that is likely available

2. Buyers will provide reasonable terms very often only on good quality receivabes 

Other sources of financing:

i. lengthening A/P days i.e. delaying payment

ii. Other loan financing

iii. More efficient inventory management 

iv. Early settlement discounts for customers

Costing approaches in management accounting

Accounting professionals should be aware of the accounting approaches available and their advantages and disadvantages. Below is a short summary:


The two traditional methods of costing are marginal costing and absorption costing. 

Absorption is in line with IFRS and allocates overheads based on the volume of units produced or hours worked.

Marginal costing splits costs strictly between variance and fixed costs. This approach may have the benefits of allowing the analyst to see how the business is likely to behave in certain scenarios such as an increase in certain costs, volume increases or price increases.

There are alternatives, however:

1. Activity Based Costing - a form of absorption costing where the overhead absorption is not based on volumes but instead overheads are allocated to cost pools which are then absorbed based on cost drivers.

2. Target Costing - this is a top-down approach. Whereas the conventional approach is to develop the cost for goods held in inventory based on the cost to produce them and order the inputs, in the target costing approach the company first estimates the market price of the final product and then will subtract the profit margin and take into account investment costs and working capital needs in order to come up with a figure for the true cost.

3. Life Cycle Costing - this is a concept that seeks to track and take into account all the product costs over the lifecycle of the product. For example, an organization that does not take into account lifecycle costing may acquire goods at the lowest possible price but incur subsequently much higher costs later. (e.g. acquire agriculture land cheaper but with certain farming obligations that may have a heavy cost)

4. Total Quality Management (TQM) - this is a structured approach to quality and cost management of an organization focusing on three main elements:

   a) Focus on internal systems to prevent faulty products, production failures etc

   b) Improvement - management needs to persist improvement of the organization processes and not accept the status quo.

   c) Customer orientation - the organization needs to aim to achieve customer needs and expectations and quality should be evaluated from the point of view of the customer.

TQM classifies quality costs under four categories:

I) Prevention costs - costs of any actions by the organization to reduce defective product or failure.
Examples: customer surveys, research of customer needs, quality engineering

II) Appraisal costs - costs associated with checking that the product meets the required quality standards.
Examples: inspection and product testing, product quality audit, process control monitoring

III) Internal failure costs - costs arising from inadequate quality of the organization's processes BEFORE the transfer of ownership to the customer/client actually occurs
E.g. if the plant due to failure produces waste, the cost of getting rid of it and cleaning the facilities can be considered an internal failure cost. Disposal costs of defective products produced is another example.

IV) External failure cost - costs arising when the ownership title for the product is transferred to the customer
E.g. warranty claims, legal claims from the customer for poor quality of service, complaint investigation and processing costs


Prevention and appraisal costs are essentially conformance costs that the organization undertakes to ensure the product meets the requirements and is high quality. The internal and external failure costs on the other hand are non-conformance.

How the Accounting Process Works

First you Collect the accounting information from data sources available.

Once the information is identified, it is posted to the books of prime entry.

These are not double entry and are just lists: sales day book, sales day returns book, purchases day book, purchases returns book, cash book, petty cash book and the journal (includes all other types of items that do not fall into the other books)

The books of prime entry are then entered into the ledger accounts which may be of any number and are in double entry format. e.g. purchase of car for cash will Dr. motor account Cr cash account

The collection of ledger accounts is known as the general ledger or nominal ledger

Separately business entities will maintain lists of individual receivables and payables due from each customer and supplier. These will be known as memorandum balances often referred to also as receivables ledger and payables ledger. These are not to be confused with the receivables and payables ledger control accounts. The memorandum ledgers are also sometimes known as subsidiary ledgers or individual ledgers. They are not part of the double entry system.

The receivables and payables control accounts are part of the double entry system and the general ledger unlike the memorandum (which is not part of the ledger either).

Errors that are NOT revealed by the Trial Balance

The trial balance is a list of all the general ledger balances. Each ledger account part of the general ledger will have either a debit or credit balance. Since the general ledger entries are all double entries, it follows that the resulting balances should also balance.

The trial balance is essentially a control system that helps identify and evaluate errors made. There are however limitations. The following are the types of errors that are not revealed by the trial balance:

1. Error of Omission: no entry at all in a case when there should have been
2. Error of Commission: entry to the wrong individual account. 
3. Error of Principle: entry to the wrong type of account e.g. $100 posted to assets instead of purchases. (both are debit entries)
4. Error of Original Entry: wrong amounts are posted to both credit and debit
5. Error of Reversal: correct amounts are posted to the correct accounts but on the wrong sides
6. Error of Transposition: posting $123 instead of $321 on both sides
7. Compensating errors: two or more erros that compensate each other

The trial balance can still be a useful accounting control system however. The following mistakes are revealed:

1. Posting to one side only
2. Posting both entries to one side only
3. Posting different figures to each side
4. An individual account added up incorrectly
5. Opening balance not brought down
6. Balance in the trial balance is different from balance on the account (extraction error)

Business Entity Types - Need to Know

There are three types of business entity types to worry about in accounting: sole trader, partnership and limited liability company. 

The following are the characteristics of each one:

1. Sole Trader

• Operated by only one individual although it may employ any number of people (only one owner!)
• No legal distinction between owner and entity so the owner is liable for any litigation claims or taxes personally (unlimited liability for debts and losses)
• The equity part of the capital structure is represented by the capital account which is increased when new capital is contributed by the owner or profits are generated by the entity and reduced by losses of the entity and any withdrawals, typically referred to as "drawings" rather than dividends. 
• In some countries drawings by the owner may not be subject to income tax or dividend tax making this type of entity more appealling for small enterprises. Sole trader entities in many countries may have simplified accounting and not be subject to audit requirements. 

2. Partnership

• More than one partner
• Unlimited liability to the partners for debts and losses
• Equity capital section consists of two accounts: capital account and current account
• Capital account is normally fixed and is adjusted when partners join and leave 
• Current account incorporates the earnings of the business that are earned less any drawings by the partners. 

3. Limited liability companies

• established as separate legal entities to their owners so shareholders are not liable for the legal entity debts
• common shareholders have a claim on the residual assets of the limited liability company
• managed by the directors of the entity which may or may not be shareholders
• if the shareholders are not involved in the business, their insolvency or death will not affect the limited liability company they own. 
• limited liability companies may be subject to increased regulatory requirements such as production and submission of audited financials, public inspection of accounts
• limited liability companies are separately taxed to its owners

ACCA Financial Accounting Terms Worth Knowing (FA Glossary)

Discount received - should be a Cr as it is effective income on the P&L. This is the case when the supplier decides to offer a discount to the business.

Discount allowed - same as a a sales discount. It is debited as a reduction in sales.

Dishonoured Cheques - presented by the customer/client but failed to generate cash for the business. They must therefore be credited on the cash book to reverse the previous booking of cash receipts on the debit side when it was originally presented.

Unpresented Cheques - cheques issued by the business but not banked by the recepient. Therefore the cash book credited by this amount.

Invoice - document issued by the supplier to the customer, identifying the details for the transaction such as price, taxes, quantity, name of each counterparty. The document represents an asset to the supplier based on which the customer owes money to the suppier.

Purchase Order - written authorization from the buyer issued to the seller to acquire goods or services. The purchase order will price, quantity and other material parameters such as quality and delivery conditions.

Delivery Note - document accompanying the shipment of goods specifying description and quantity

Lodgement - act of paying into a bank account

Drawings - withdrawals of cash by the owners of the business from the business

Sales Returns = Returns Inwards

Purchase Returns = Returns Outwards

General Ledger aka Nominal Ledger - a list of all credit and debit transactions with details on each

Trial Balance - a list of all credit and debit ending balances in one table in double entry format. Auditors will start with the trial balance but will use the general ledger to trace any errors in it.

Drawings - in a partnership this is an account separate from the capital account which covers the funds withdrawn by the partners from the business

Imprest System (Imprest Amount) - petty cash management system involving a float which is regularly topped up to a certain level of funds called the imprest amount which is normally sufficient to cover the expected cash needs over the period

A/R ledger control account (not to be confused with the A/R ledger account)

A/R ledger account (Memorandum) - this is a separate list of individual Accounts Receivables for each counter party

Books of Prime Entry: (list-format books) include sales day book, sales returns day book, purchases day book, purchase returns day book, cash book, petty cash book, journal (all other transactions)

Ledger accounts - double entry accounts such as e.g. plant account

Types of Exchange Rate Risk

1. Transaction Exposure - I am a US investor expecting to receive 1m Euro in 2 years from a client. I don't know what the euro will be worth in 2 years.

Transaction exposure can be mitigated using derivatives. I can short a 2-year USD/EUR forward to mitigate the risk



2. Translation Exposure - this is associated with accounting when on the financial statements one currency is converted to another without necessarily any real economic gains or losses.


3. Economic Exposure - when changes in the currency rates affect the competitive standing of the business. A Russian consumer products manufacturer (with expenses and revenues in Rubles) is likely to sell more products to foreign clients if the local Russian currency devalues

Wealth Management Concepts

Goals Based Planning Financial Planning - modifies traditional MVO and accommodates for behavioral finance. The financial asset portfolio is dividend into risk buckets:

1. Personal Risk - cash, money market funds, personal residence is included

2. Market Risk - fixed income and equity market portfolio

3. Aspirational - concentrated positions etc

Primary Capital = Personal Risk Bucket + Market Risk Bucket

Surplus Capital = Aspirational Risk Bucket


Estate Planning Concepts:

Human Capital = Net Employment Capital = Present Value of Income Generated Over Lifetime

Core Capital = Amount of assets needed to meet all the individual's liabilities + reserve for unexpected needs

Excess Capital = Total Assets (financial + human capital) - Total Liabilities (financial and non-financial)

We can use mortality table or monte carlo simulation to estimate core capital

Notice that if a man with all the same characteristics as a woman but who is likely to live less, his core capital is likely to be less

Individual Risk Management Concepts

A risk with the loss characteristics of high frequency of occurrence and low severity of loss, such as dental cavities, is best managed through risk reduction—for example, through proper dental hygiene. A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, is best managed through risk transfer. A risk with the loss characteristics of low frequency of occurrence and low severity of loss is best managed through risk retention, such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item.

GIPS Need to Know List

REQUIRED Disclosures

1. Definition of the Firm
2. Total assets under management (all types)
3. Composite description and creation date
4. Benchmark description
5. Currency used
6. if gross of fees returns are presented must disclose any deductions other than direct trading expenses. 
7. for net of fees returns must: a) disclose any deductions other than trading expenses and investment management fees b) if actual or model investment management fees are used and c) if returns are net of performance based fees 
8. State that composite descriptions are available upon request
9. Disclose valuation & performance measurement policies upon request
10. Disclose presence of leverage, short positions and use of derivatives. 
11. Significant events that would help interpret performance e.g. departure of key investment managers
12. For any non-compliant performance betfore 2000, must disclose period of non-compliance
13. If the firm or composite is redefined, must disclose date, description and reason
14. Must disclose minimum asset level 
15. Must disclose if the name of the composite was changed. 
16. Must disclose relevant treatment of taxes if material and provide benchmark returns net of withholding taxes if available
17. From 1st of Jan 2011, Must disclose any material differences in valuation sources and exchange rates used. (e.g. i used reuters for valuation in one portfolio and Bloomberg in another)
18. Must disclose any conflicts between GIPS and local laws/regulations
19. Must disclose carve out cash policies prior to 1 Jan 2010 (after carve outs were no longer allowed)
20. Must disclose fees included in the bundled fee
21. Disclose any sub advisors and periods they were used from jan 1 2006
22. For periods prior to 2010, must disclose if portfolios were not valued at calendar month end or last business day
23. After 2011, must disclose any material subjective unobservable inputs employed for valuation purposes and any difference in the valuation hierarchy than the one recommended
24. If no benchmark exists, must disclose why
25. If benchmark is changed must disclose date & reason
26. For custom benchmark, must disclose details of the benchmark including components, weights and rebalancing process
27. If the firm has a significant cash flow policy, must disclose how the firm defines it
28. Must disclose if a 3-year annualized ex-post standard deviation for the composite or benchmark is not presented because returns are not available
29. If the firm decides that the 3-year standard deviation is to be excluded because it is not relevant, must disclose why it is not relevant and a description of the alternative risk measure used with reason for its use
30. Must disclose if performance from past firm or affiliation is linked to the performance of the firm

Note valuation hierarchy:

1. Objective unadjusted market prices for similar investments in active markets

2.  Quoted prices for similar investments in non active markets

3. Use market based inputs other than prices

4. Subjective unobservable inputs

RECOMMENDED Disclosures

1. Disclose any material changes to valuation or calculation policies

2. Disclose material differences between the benchmark and the composite's investment mandate, objective or strategy

3. Key assumptions used to value portfolio investments

4. List of other firms contained within the parent company (if relevant)

5. Disclose any subjective unobservable inputs used to value portfolios prior to 2011 (after 2011 mandatory to disclose)

6. Disclose sub advisor used for periods prior to 2006

Investment Policy Statement Notes

Return Objective

Calculated based on wants and needs e.g. accumulation of wealth goals for retirement, financing child education etc

The return objective may be single stage or multi stage. eg. the investor may earn income upto retirement agressively investing in equities but after retirement his return objective could be lower focusing on higher income generating assets. this is a multi stage objective firstly to retirement and then post retirement.

If there are multiple goals, the investor may adopt a goals based asset allocation, targeting a certain return for each bucket - personal risk, market risk and aspyration.


Risk Tolerance

1) Willingness to take risk

2) Ability to take risk

Recommendation should not exceed willingness to take risk

Situational profiling:

Take into account:

a) Source of wealth - affects the willingness to take risk. if one inherits the wealth, he has lower willingness to take risk vs entrepreneur who actively earned his wealth and would be more willing to accept risk

b) Measure of wealth - affects both ability and willingness. if one views his wealth is high, he is likely more willing to accept risk. If objectively ones wealth is low, then his ability to tolerate risk is likely lower

c) Stage of life - ability to tolerate risk falls with age

Constraints

1) Time Horizon - if the investor is very young, he has a very long term time horizon and can accept more volatility in this portfolio

2) Liquidity - retired couples who rely on investment portfolio income would need more liquidity and therefore may not be able to invest in equities that dont pay dividends.

3) Tax - the investor may be in a high income tax bracket and therefore would benefit from investments generating returns from capital gains.

4) Unique Circumstances - e.g. special goal to make a payment or donation at a certain date 

Cross Hedging and MVHR

CROSS HEDGE Explained

It is often the case that various assets in the portfolio and exposure to different currencies with imperfect correlation between them creates a natural hedge also known as the cross hedge or proxy hedge or macro hedge. A cross hedge is an indirect hedge as opposed to using forwards to hedge which is direct.

For example historically the Brazilian Real and the Russian Ruble have been closely correlated. A short position in the Real and a long in the Ruble can reduce overall portfolio risk (as measured by volatility). In this case derivatives and forward contracts are not needed and sometimes they are not available or illiquid.

It is important to note however that whenever a cross hedge is used to minimize portfolio risk, basis risk is incorporated into the portfolio which in a sense is produced by the fact that we are assuming that these correlations between currencies will hold in the future.

For example if we were to invest in Russian Ruble Bonds and Turkish Bonds on the premise that they have lower correlation and that the Russian economy is a net exporter of oil and gas while Turkey is a net importer. We would then use cross hedging to reduce portfolio risk by including both Russian and Turkish assets in the portfolio.

Then a crisis happens due to Turkish debts skyrocketing and investors becoming frightened, pulling out of emerging markets in general. This is called contagion. In this case the correlation between the currencies of the two countries can change significantly, now the currencies both fall and correlation increases towards positive 1 as investors sell their Liras and Rubles to purchase USD which is considered safer.

The risk that the correlations between the two currencies changes is the basis risk.

Basis risk is introduced by the cross hedge which is an indirect form of hedging while a direct hedge with a forward contract for example will not produce basis risk.

Minimum Variance Hedge Ratio (MVHR)

When using forward contracts to hedge, often an ideal hedge does not exist and hedging is also often expensive. Finding an optimal hedge that is less than 100% often known as the minimum variance hedge is often the best solution.

an ordinary least squares is typically used.

return in domestic currency = alpha + beta x (FX return) + resitual 

the beta is given as correlaton of (Rfx, Rdc) x std (Rdc)/std (Rfx)

The beta is the minimum variance hedge ratio

in the case of basis risk, it is expressed in the instability of beta.

Note: If I am long USD/AUD, I am long the base currency, i.e. AUD


Example with Rubles and USD

I am a USD investor but am originally from Russia and like to have a little exposure to the local equity market in my portfolio (presumably because I think the Russian equity market is very cheap). I would like to hedge my Russian equity exposure however back to USD because I live in the US.

I note that the correlation between the returns of the Russian stock market in Rubles and the % change in USD/RUR is +0.6 i.e. when the Russian Stock Market goes up the Ruble tends to go up as well most of the time, so they to some extent move together but not perfectly.

I decide I want use forwards, so I would go short a USD/RUR forward but I need to know the nominal amount and I wish to use a minimum variance hedge ratio for this.

I regress Rdc = alpha + beta x Rfx + residual and find the beta of 1.35 fits.

If sport USD/RUR = 0.01666 and I invested $1m then I have 60m RUR invested in Russian stock market. I need to go short USD/RUR forward for the nominal amount 60m RUR x 1.35 = 81m RUR

Because the Ruble and the Ruble stock market is positively correlated, we need to hedge more than the Ruble exposure in order to account for the FX volatility.

Credit Analysis & Concepts

1. Credit Analysis:

When analyzing the fixed income opportunities use the 5 Cs of credit analyst which are

a) Character - how honest are the management and owners? Having they screwed over lenders and creditors in the past? All these sorts of questions need to be answered before contemplating becoming a creditor of the company

b) Capital - how much the borrower has put up in capital into the business. If for example an LBO firm seeks debt financing, it is worth while looking at how much equity the LBO firm is willing to put up from its side and how much capital there is in the business to date. The more equity capital the project has, the safer it is for the creditor to provide financing.

c) Capacity - ability of the business to meet its credit obligations. If there is a cushion to protect companies if the operating performance declines or if the revenues and profits are resilient due to the non-cyclical nature of the business, then the company is more credit worthy.

d) Collateral - if default occurs, the creditors should look at what assets they can use to cover whats is due to them. Banks typically pledge company assets but in the case of fixed income investors they would look at what assets can be recovered after the more senior creditors recover their money and the liquidity of those assets. For example a business with a factory and some real estate issues a bond but also has a bank loan which is guaranteed by a mortgage over the real estate. (the bank would have a senior claim over the real estate of the company in this case)

In this case if the business collapses, the bank can take over the real estate, liquidate it and recover its money but the fixed income investor may be stuck with an illiquid and abandoned brownfield site that would be sold for cents on the dollar materializing in a large loss to the fixed income investor.

e) Covenants - these could be negative (restrictive) or positive (affirmative)

Affirmative covenants are things that the issuer must do like maintain insurance or certain liquidity ratio.

Negative coventants restrict the issuer from doing something that is not in the interest of the creditor like paying large dividends or increasing leverage beyond a certain level.

2. Concepts

It is often worthwhile to understand key investing concepts. Here is a summary:

a) Credit risk has two components default risk and loss severity (also referred to loss given default)

Some fixed income investors use the formula:

credit spread = annual credit loss risk = (probability of default) x (1- recovery rate)

b) Spread Duration - a concept useful to comparing credit risk of bonds especially with a floating rate element. Spread duration measures the price change due to a change in the credit spread.

change in the bond price = change in the bond price due to a change in the risk free rate + change in the bond price due to a change in the spread.

Typically a standard fixed interest bond will have a modified duration equal to the spread duration. This is however not the case for floating rate bonds which have very little duration but could have substantial spread duration.

Spread duration is most useful for investment grade bonds.

Spread risk generally refers to the change in the bond price relative to a risk free bond due to spread widening (Credit Migration). Credit Migration refers to the decline in credit quality of the issuer leading to lower credit ratings and an increased spread.

c) Empirical Duration - is based on regression of actual bond prices and interest raEmpte changes

Effective durations are based on the present value of future expected cash flows should bond yields change either up or down.

Empirical duration tends to be lower than effective duration for investment grade bonds where as for high yield bonds the difference is negligible.

Investment grade investors primarily experience interest rate risk while credit and spread risk is secondary. For high yield bonds investors on the other hand

d) Liquidity Risk - ability to buy or sell quickly in the market at near fair market value.

Options Strategies List

1. Covered Call: Long Stock + Short Call (income strategy)

2. Protective Put: Long Stock + Long Put (insurance strategy, the exercise of the put is near the current stock price, also known as a married put)

3. Collar: Long Stock, Out of the Money Short Call and Out of the Money Long Put

4. Bull Spread:

a) Long Call at X and Short Call at X+Y (Bull Call Spread)
b) Short Put at X and Long Put at X-Y (Bull Put Spread)

5. Bear Spread:

a) Short Call at X-Y and Long Call at X (Bear Call Spread)
b) Long Put at X and Short Put at X-Y (Bear Put Spread)

6. Seagull Spread:

a) Bullish Seagull = Bull Call Spread + Sell Put
b) Bear Seagull = Bear Put Spread + Short Call

7. Butterfly Spread:
 Long Call at X1 + 2 Short Calls at X2 and Long Call at X3 (Bull Call Spread + Bear Call Spread)

Alternatively you can construct a butterfly spread with a Bear Put and a Bull Put

The Butterfly spread is a bet on low volatility that the share price will not go up or down a lot.

A short butterfly spread is a bet on higher volatility

8. Condor Spread: Bull Call Spread and Bear Call Spread. (Volatility Bet)

9. Straddle: Long Call and Long Put Both at the Same Strike Price

10. Strangle: Long Call and Long Put wtih Different Strike Prices

11. Short Risk Reversal: Long Call + Short Put

12. Box Spread: Bear Put Spread + Bull Call Spread

13. Put Spread: Buy Put and Short Call



It is worth while to recall the put call parity relation when considering these:

p+S=c+X/(1+rf)^T
(for European options)

Portfolio Performance Evaluation Risk/Return Measures

	Type of risk measure	Advantages	Comments	Comments 2
Sharpe Ratio	Total Risk		Assumes normally distributed returns, based on the CAPM, slope of the CML	Biased upwards for hedge funds Uses portfolio total risk instead of systematic risk
Sortino Ratio	Total Risk	Good for hedge funds Good for assets with skewed distribution of returns	Improves on the Sharpe Ratio that penalizes for good performance which is incorporated in the up side deviation
Information Ratio (Appraisal Ratio)	Total Risk	Used to measure active performance of mutual funds	Higher information ratio (0.4-0.6) is considered better. The index has zero IR	IR = active return/active risk IR = IC x BR ^ (0.5)
Jensen’s alpha	Systematic	Used frequently to evaluate mutual fund performance	Based on the CAPM
Treynor	Systematic	Overcomes the Sharpe ratio limitation that it uses total risk	Slope of the SML
M squared	Total Risk	The Sharpe ratio is awkward to interpret when it is a negative value. M squared is always positive.	A skillful manager will generate an M2 greater than the return on the market	Rf + SR of asset x Market STD. M^2 measure ranks in agreement with the Sharpe ratio

Taxable vs Tax Exempt Bonds

Note that taxable bonds have a flatter yield curve and in the case of an upward sloping yield curve the investor has less incentive to extend duration as there is relatively less upside in higher duration bonds due to tax effect

Tax exempt bonds generally offer a greater incentive to extend duration compared to taxable bonds. Therefore they would have a steeper yield curve.

A US investor may decide that it is more efficient to place taxable bonds in a tax exempt investment account or a tax deferred one whereas tax exempt bonds can be placed in a taxable account.

Four Types of Liabilities

Type 1 - Known Future Amount, Known Timing

Type 2 - Known Future Amount, Unknown Timing

Type 3 - Uncertain Amount, Known Timing

Type 4 - Uncertain both Amount and Timing