Resumen fincorp managers should be mangers should take

oriented(focus) to into acocount the

Wehat is financie:
increase the Long interes of the parties
.What invesment opporntunies mus be term value of the that contract with
pusued? firm the firm
Shouel the frim seek one goal?
-how the firm mus t be finacnied to obtain
the neecsariso capital? Shloudl this objective be value
maximization?
How the frim deals with the short-term
financial activites? Supoose that the only stakeholder is a group
of stockholders. Most of time, each of the
Differences between accounting and functional areas within a firm has
finance contradicting objectives.
Accounting Fianncie
-Divide by -its being divedide Risk Return
mangamene and into: -Survivial -Sales or market
fincnial accounting 1)corporate -Avoid banrupcty share maximization
-it doesn take into financie: deals with -Maintain a constant -Cost minimization
account the time outside earnings growth -Benefit
value of money(the investorsexpectataio maximization
implicit oppontuniy ns The most important OBJECTIVE is VALUE
cost) 2)small business MAXIMZATION OF SHARES.
-it treats CF from finance: deal with
The goal of a corporate firmmaximze the
accounting owners eexptations
LT value of the firm
perspective -It takes into account
-market value Firm= firms stock price=
the time value of
wealth of the firms owners
money
-the oinly way to fulfill this goal in the long
-it treats CF from a
run is to take into consideration the
financial perspective
stakeholders interes
In order to hold the 3 identy:
-information transparency
-market efficiency
Corporate financia Small business -corporate social
finance responsibility(financial,social, eviormental)
-the firm usually has -the owner of the -no market imperfections, such as agency
many owners firm is usually a costs and asymettrica information
-the frim discloses family or an indivual
more financial entreprnuer.
information - ther is less Agency Problems and Control
-Ther is a separation transparency with of the Corporation
between ownwership the Agency relationship:reation in which the
and control innformation(more principal (syockholder) constracts an
-the main objeticve assimetric agent(manager) to rrpresent his interes
is to create value in imformation) Agency problem: conflicts of interes that
the long temr -ther is no separation arise between the stokholders and mangers
between ownership of a firm
and control Agency costs: thos rectly or indeirectly
derevided from aa agency problem

Shareholder Satakeholder Types of agency costs

theory theory Direct costs: Indirect costs
The actions of the The actions of the Corporate The manger
expenditure that impkennt a decision
ebenficts the that reduce the
management but not benefict of
the stokholders stokholders.
Expense asosociate
to monitoring the
behavior of
managers
Principles of Corporate Finance
-The goal of the financial mangaer msut
be to creat value in the long term for
the firm shareholders.
-the value of the company is the value
that market investors assign it.
-the costo of capital is a withge average
cost of debt and equity of the firm.
-diversifaction within the firm doesn
create value because one assumes well
diversified market investors. Hence, the
value additivity principle holds.
-one must value every asset as it were
to be trade in te capita market
Anlisis y diagnstico financiero:
Objetivo y etapas
El Balance Financiero: Estructura y
elaboracin
Anlisis horizontal de Estados
Financieros
Anlisis vertical de Estados Financieros
Ratios financieros
Perfil financiero empresari
Anlisis y diagnstico financiero:
Objetivo y etapas
Process that conssit in detemrin the
fiuanncial profile of the firm, provideing a
initial view to prompted or define casuses of
problems found.
Etapas
1)compilation of relevant inside information
of the firm: vision, mission, golas, politics,
sector, EEFF
2)fianical balance
3)horizontal and vertical analyst of financial
statements
4) soruces and uses fund statements
5) finantial ratios
6)determine the fianantial profile of the firm,
od causes of problems and alternatives of
solution.
Financtial balance
fiantial rport - results of making
changes in the balance sheet -
facilite to the Finaical analyst in
taking investment and financing
decision in short term.
Struture:
-Permanent resoruces(PR)
-spontneus liabilities (SL)
-Negociated resourcers(NR)
-working cpaita(WC)
-Operational needs of funds(ONF)
-Permanent resoruces(PR): all the
resources of Long term(own or third
parties:third party fund) that will remain
during more than one exerceise.
PR= non current liabilities (NCL)+
equity(E)
spontneus liabilities (SL):all financtial
resources of third parties in short term
generated in the court business. These
are made up by all current liabilities
accounts.
If sales raise so accousnt payable raise and
taxes payable accounts raise
Negociated resourcers(NR):all third
 party financial resosurcesor funds an between accounts the account,
that were negociated in favorable and take out some monetariy amounts
conditions for the firm. relations. of the accounst
-absolutely negociables: interes payable, divided by total of
diviedens payable the corresponding
-realtively negotiables: negociable sttatment.
parts, spontaneous parts.
NR= CL-SL Income Statment: Balance sheet:
Working capital (WC): it is a porction of It is considere all It is consdiered
Permanen resources to be invested in net sales as 100%, total assests as
short term. Its origin is from Long term and it is claculedt the 100%. And all the
and it is used for short term. It is other % for the accounst realtied
provided from third parties other accounts in with total assets.
WC= CA-CL= PR-NCA relation with net
Operational needs of funds(ONF): sales.
finantial resources from third parties
(negociated resoruces ,long term debt
,equeity) that will be encessary to finance
current operatins of the firm , that is
short tmer investments(Current assets)
ONF= LT debt + eqeuity+ NR

Uses and soruces fund statements

Allws to determine la finantial
estructure of the firm, it means the
relations between assets and
liabilities
1)Determine the differenes between
accounts balances 2 consecuitve
balance sheets
2)classify differences found in soruces or
uses fund
3)test that the total sum of soruces=
total sum of uses of fund

Horizontal Vertical analyst

analysist
-Allows to compare -It consist in
favorable and determine the
unfavorable relative Fiantial Ratios
tnedences of the importance of the -It is a quotient determined by the
fiannciacial and Balance sheet and division between balance sheet
operationals income statement accounts or income statement or
outcomes accounts , with the between a combination of both kind of
-Tendencias are not aim of knowing accounts
calculated, which accounts -ratios arise from the necessity of
necessary, for each are in finantial analyst to set or stablish relations
Finantial statement problem accoriding between accounts that have some
accounts, because to financital ratios. dependence bweteen them
the main idea is to To obtain the Liquidity, profitability, solvency and
make a comparison proportional value of
management
-A ratio is not signficative by itself it
has to be compare to some
benchamark. The changes in ratios of any
date must be justify by a change in
accounts that comform them.
The benchmarks to make the
comaprasison could varios types, ratios of
leaders firms of the sector,ratios of
total of industry.
Characteristics
1) Allows to determine the initial
fiantial profelie of the firm
2) Provide estimated indicators of the
finantial factores when are dived
the flow accounts with stock accounts
3) To interpret appropriately a finantial
ratio,it has to take into account a
unit of measure (N times,N days,
%) temporal evolution(horizontal
analysist) and ratios of sector
Analslisi de EEFF.
Capital contable : it is what rest of the firm
for the shareholders after compling
with its obligations.
Lso activos aparecen en el orden en que se
basa en el tiempo que se reqeurira usar
para que una empresa en macrcha los
convierta en efectivo
Los apsivos y el capital contable se
presentan ene le roden en que se
pagrian a travs del tiempo.
When the balance sheet is analyzed take
into account 3 aspects: liquidity, debt /
equity, value y costs.
-Liquidez: it is the quickness and easiness
to convert asses in cash (without value
loss)
Indicate th payment capacity and obligations
in short term of the fim
Accounts payable goes after the
adjustment of doubtful accounts
(cuentas incobrables).
-El inventario: are raw materials that will be
used in production, products in process
and final products.
AF: son el activo menso liquido
AF tangibles: states , plants and
equioment.
AF intangibles: mavca comercial o patnente.
Los acivos liquidos tinene tasa de
rendimeinto bajas que soa ctvios
fijos.ej: el fectvio no genera ingresoso sobre
inversiones.
Whenever while the firm invest in liquid
assets, sacrifice the oportunity of
investing in more profitable securities
-Deuda y capital:
Liabilities are contract obligations of
payment of some quantity or interest in
some period.
Capital contable: it is a resitudal right , not
fixed, It is the share of stakeholders in
accounting terms. The accounting value
for the shareholders raise when retain
earnign are added .
The value of a company it is not in a BS:
buena admisnitacion, propiedad
intelectual,exsitencia de condiciones
eocnmcias favorables .= vlaro de mercado
Estado de resultadso:
Measure the performance during some
specific period
I-G=utilidad.
Si el BG es comouna fotografa instatanea, el
Ede resutlados es el video que registra lo
que lsa personas hicieron entre dos
fotografas instantneas
-It is diveide in operative seccin:
between incomes and expenses.
-Non operative seccions: financing costs
susch as interests.
The change in working capital is higher
ina a firm with more growth.
Free Cash Flow: it is the CF the firm can
be divided freely for creditors and
shareholders that its not necessary for
invements in working capital or fixed
assets poruqe no es necesario par als doesnt include difrences in earnigns
inversiones en KL o actviso fijos. orgined by the capital streuctures of
firm(interes paids and taxes.
Analsisi de EEFF:
EBITDA: antes de impeusto, inters y
Since comparison firms with differents
depreciaicon.
sizes deoesn make sense. . it is used %
EBITDA=EBIT+Amortizaicon y depreciaicon.
BG %:
Amoriazaicon no va al ER. Es bueno porque
-si el AC es 19.7% de los AT el 2012, agrega dos aprtidas que no generan
estorepresenta un aumento de 19.1% en movimiento de efectivo(depreiacion y
2009. amortizaicon) a EBIT. Por tnato es una
emdiada de flujod eefectivo de oepraicon
-el PC cayo 16 a 15.1% del total de pasivo y antes de impeustos.
capital en ese mismo periodo.
Analisis de ratios financieros:
-El capital contbale subio de 68.1% del total
del apsivo y capital contable a 72.2%.
En general the liquidity measure by the
CA compared to CL rise along the year.
Besides the debt fall as a % of total
assets. This means that BS is stronger.
ER %
Indicates what happens with each dlar
in sales.
-los gastos de inters consumen 0.61% de
cada doalr de ventas
-los impuesto consumen 0.81%.
-to the end 0.157 de cada dlar de ventas
llega como utilidad: de este moneto 0.105 se
retine la empresa y 0.52 paga de cda doalr
apga dividnedos.
-una cifra rlevante es e l % del costo. EJ
0.582 de cada doalr de ventas se destinan al Otr
Csotos. a forma de evitar lso problemas que
-net income reflects the difreneces between plantea la cemoraicon de comeias
capital structure and firms taxes. Firms fiefrente tamos cosniste en calcular y
interes paid are discounted from the comrpara las razones finacneiras.
operational earnings to clauclate net income. Las razones financieras en si misma dicen
UN/acciones en circulacin= earnings per poco acercad e una mepresa porque varian
share =11. en grna emdaida de una industria a
otra.
EBIT: earnings before taxes and interest. It
is known as operational eanings in Exsitne 2 emtodos bsicos: analsis de
income statement before extraordinary and tendencias en el tiempo y el analsisi de
operacional accounts. grupos similares. En ele anaslis de als
tnednecias hay raoznaes de al empresa
Oeprational expenses are discounted form que abracan cierto epridoej: 5 aos ys e
operation incorme. It is useful because it examina como cmabian cada razn
durante crieto epriodo. En el analsias de
grupos simislares se comrpan als
razones financeiras de una empresa
cona sla de otras.
Problemas es que las pesoans no las calculan
de als mssmaim amneras.
-se deb documentar como se calculo cada
una.
-para comrpara se deb saber com se calcula
la otra.
I)Meidad de liquidez o solvencia de CP:
(3)
Cpacida de la epreas para pagar cuentas en
el CP. S ebbasn en AC y PC
Son de inters de acreedeores de CP.
-ssus valros dn libros y emrcado son
similares., s epeduen cambiar con rapidez
noes guai confiabel para el futuro.
1. RAzon ciruclante:
Razon circulante= AC/PC, daod que s
eocnveirten a lso alrgo de 12 meses, 1.31,
es 1.31 dolares de activo ciruclante par
aapgar 1 doalr de PC.
-para un acreedor CP: cunaot mas alta
mejor.
-para empresa mas alta indica liquidez
pero tmabien peude indicar usao
indeficiente dele fectivo y otros AC.por
ello es bueno esperara una razn >=1, si
fuera menor que el KL neto(AC-PC) <0
engativo. por tnato no seria una empresa
saludable al emnso en al amyoria.
-si un aempresa solicita perestmao de LP. El
efcto a CP seria un auemnto de dieno y
auemnto de deuda de LP. El PC no se
veria efectado por tanto la razn
cirulante auemtnaria.
-si una empresa va a liquidar sus ceuntas
con lagunos proeveedores ya creedroes
de cp.
-La razn ciruclante si era mayor a 1 se hace
cada vez mayor a a1. Pero si era inferiror a 1,
ser mas peqeua.
-si una empresa comrpa inventario no le
sucede nada a la razn ciruclante porque el
fectivo diminuye mienrtas el inventario
auemtnas el AC no resutla afectado. De
igualmenra si cimpra con deuda, aumenta
PC pero auemtna AC en la mismo monto
-si vende mercancas la razn circualnte
auemntaria porque el inventario registr
costo y la vena serai mayor, ya sea en
efectivo o a crdito es > que el
decremnto del inventario.
Un RCiruclante. Bajo puded no ser mala
para una empresa que tiene una
reserva cuantiosa de capdida de
endeumaneinto no utilizada.
2. Razn rpida o acida:
-el inventarioAC menso liquido. Y que su
valor en libros es el menos confiable a
valro de mercado porque no considera la
caldiad el inventario, pude ser daada o
perida.
Los inventarios relativamente grandes so
con frecuneia una seal problemas d
eCP. La empresa peude haber
sobreestimado als ventas y haber
comrpado o prodcuido ene xceso. Peude
tener en este caso una parte importante
de su lqiuidez comprometida en un
inventario que se meuve muy despacio.
Razn rpida=(AC-inventario)/PC
-el uso de efectivo o crdeito no afecta la
razn ciruclante sino reduce la razn
rpida. Dado que si pagas con efectivo
reduce el AC y auemtna inventario prot
anto cae RR, si pagas con deuda auemtna
pasivo circulante y aumenta inventario
pro tanto cae Razon arapida.
-RRapida=(708-422)/540= 0.53 veces.
Auqi el inventario representa casi la mitad
del AC prot anto si es un producto dificl
de vender seria preocupante.
Si una empresa tine una razn cirucalnte
de 0.89, y razn rpida de 0.13 es
rpecoucpante porque su inventario
representa una parte importante de sus
AC si es que estos son bastantes.
3. Razn de efectivo.
Un acreedor de muy corto plazo le
interesa al R de EFctivo
Razon de efectivo= Efectivo/PC
2)Medida de solvencia de LP (6)
-determinar al capidad para apgar
obligaiocnes de LP,su apalancmaiento
financiero.tambine se llaman razones d
aplancamiento. 3 se usn:
1. Razn de deuda total:
toma en cuenta todas las deuda de todos
los vencimientos de todos los
acreedores.
Razon deuda total= (AT-Capital total)/AT
Equity: Utilidades retenidas + acciones
comunes
RDT= (3588-2591)/2588= 0.28,
-Se puede decir que usa 28% de deuda para
fincanciar los actvios o inversiones de la
empresa totales. Tien 0.28 soles de deuda
por cada 1 sol de activos. Por tanto tien 0.72
doalres de capital por cada 0.28 dlar e
deuda.
-En este caso, el capital total incluye las
acciones preferentes, si las hay.
-Un numerador equivalente de esta razn
(Pasivo circulante + Deuda a largo
plazo).
-si es alto o bajo si es buneo omalor
depender de la estructura de capital
sea de importancia.
-se peduen dereviar dos razones: razn
duda a capital y el multiplicador del capital.
2. Razn deuda a capital= deuda
total/capital total
= 0.28/0.72=0.39 veces
3. multiplicador del capital= AT/eqeuity
total =equity/euity+debt/equity= 1+ razon
de deuda capital
=1/0.72= 1.39 veces
Multiplicador de capitl=AT/equity total=
(capital total +Deuda total)/capital total= 1+
razn de deuda de capital
Las 3 razones : Multiplicdao del capital ,
deuda total ,deuda capital-se puden
calcular con una sola de ellas.
4. razn de cobertura intereses o Razn
de veces que sea ha ganado interso
(TIE)o
Otra mediad comn de la solvencia a LP es la
razn de veces que se ha gnado el inters
(TIE:times inters earned)
TIE = EBIT/inters = 691/141= 4.9
veces
Esta razon mide el grado en que la
empresa cubre sus obligaciones de
pagar interes y con frecuencia se
denomina razn de cobertura de inters.
La cuenta de inters se cubre 4.9 veces.
5. Razon de Cobertura de efectivo
El problema de la razn cobertura de
intereses es que se basa en EBIT que no es
en realidad una medida del efectivo
disponible para el pago de interes.
La causa es la depreciacin y
amorizaicon, gastos que no preseprentan
momvimeinto de fectivo, se han
deducido. Daod que lso inters son flujod e
efctivo.
Razon de cobertura de efectivo: (EBIT+
depreciacin +amortiaicon)/inters=
EBITDA/interes
= 691+276/141= 6.9 veces.
El EBITDA es una mediada bsica de
alcapidad de la empresa para genera
efectivo de la oepraicones y con frecnai
se usa como medaida del flujo de fectivo
disponible para obligaicones fiancnieras.
6. Rzon deuda que devenga intreses
a largo palzo s eusa en contratos d ed
deuda.
= deuda que devenga
inveteres(documentos x apgar: +deuda
de LP)/EBITDA = 0.68 veces
-los documentos x pagar muy
probablmeente osnd euda bancaria y
deuda de LP
Lso valro <1 se consdieran muy fuertes
y los valroes <5 son dbiles. Epro es
encesaio comrpara com empresas
similare
3) Mediad de rotaicon de activos (4)
Mide la efeicnicai con que se usan los
actvios.
2 inportantes AC: inventario y cxc
1. Rotacion de inventario:Nde veces
que cmabia el invetario
Durante el ao se tuvo un costos de bienens
vendidos de 1344. Al final del ao el
inventario fue de 422.
Rotacion de inventario=(CV)Costo de
los Bienes vendidos/inventario
Ej: 1344/422=3.2 veces
-La empresa vendio o renovo la totalidad del
inventairo 3.2 veces a lso largo del ao.
-Caunto mas alta es la razn mayor efeciaic
se admsnintra el inventario, quiere decir
que se esta vendiendo mas de lo que se
esta quedadndo sin vender.
-se puede calcualr cuanto tiempo se
reqeuirio en proemdeo para realziar la
rotaicon.
2. Razn de das de inventario= 365
dias/rotacion del inventario
Ej 365/3.2= 114 dias se demora el
invetario en rotar 1 vez
El inventario dura en promedio 114 dias
antes de que se venda. Es decir todo el
inventario hasta que se acabe se demora
en vender 114 dias.
-ademas se reqeuriana alrededor de 114 dias
para procesar el inventario actual.
Eje: Esta compaa tenia existencia para
144 dias, pero si el mercado requiere 60
quiere decir que se debo mejorar la
caida de ventas.
Pero claro tambien son menso das para
los productos que se venden mas rpido.
3. Rotaicon de CxC
Las mediada del inventario proprocionan
alguna indiciacon con respecto a la rapidez
con que se venden los productos.
Aca se ve la rapidez con que se cobran las
ventas
R de cxc= ventas al crdito /CxC
=2311/188=12.3 veces
Se cobraron las cuentas a crdito
pednedientes y de neuvo se rpesto el dienro
12.3 veces durante el ao. osea vendo al
crdito 12 veces mas de lo que queda por
cobrar.
Si >1 quire decir que doy muchio crdito
comprado comparado con lo que me demoro
en cobrar, por lo tano esta bine porque doy
bastante crdito pero tmabine cobro rpido
que queda poco por cobrar.
Si esbajo entonces doy poco crdito o es que
que me demoro mucho en cobrar.
4. Dias de ventas por cobrar
Esta razn tienn mas sentido si se conveirte
a das: das de ventas en CxC o periodo
promedio de cobranza.
Das de ventas en CxC = 365
dais/rotaicon de CxC
Ej=365/12.3= 30 dias
En promedio las ventas a crdito se
cobran en 30 dias.
-tambien se peude afirmar que ahoy dia a
empresa tien 30 dias de ventas
pedneidnetes de coro.
5. rotaicon de activos totales.
Si se toma distnacioa de las ceuntas
epsecifica, com los inventarios o las cuentas
x cobrar.
Rotacion d activos totales:
Ventas/activos totales
Ej 2311/3588=0.64 veces
Por cada doalr de activos la mepresa
genera 0.64 doalres en ventas.
Entonces 1/0.64= 1.56 aos necista la
empresa para hacer una
rotaiconcmompleta de los activos.
Medidas de Rentbaildiad (4)
1.Margen de utilidad
Margen de utilidad= utildiad neta/ventas
Ej 15.7%, genera 16 centavos de utilidad por
cada 1 dlar de venta
2.Margen EBITA:
-Es una mediada de flujo de efectivo de
oepraicon antes de impuesto.
-suma lso gatos que no rpesentan
movimeintos de efectivo y no incluye
impuestos ni gastos de inters.
-examiena de forma mas firecta lso flujos de
efectivo de oepraicon que la utilidad neta,
-tampoco no incpropra el fecto de
estrucutra de capital ni imuestos, es
decir que s efinancia con capital propio
de la empreas.
EBITDA/Ventas= 967/2311= 41.8%
Si no se intervienen otros factores , es
deseable contar con un margen de
utildiad relativemnte alto.
-esto meustra a razones bajas de gasto en
relaicon a las ventas.
-peor con freceunia intervienne otro factores.
-si reduce el rpeico de venta auetna el
volumen de unidades vendida, pero
ocasiona que lso magens de utilidad se
reduzan
-la utilidad total(flujod e efectivo operacitov)
pude auemtnar o caer, por tnato el ehcho
que lso amrgenes sean emnore no
necesarimente es malo.
Los precios son tan bajos que la empresa
peierde dienro en todo lo que vende
pero recupera pro volumen., esto es
falso.
-los mrgenes de utialdia son muy diferente
en cada industria.
3. Rendieminto sobre los activos:
El rendimento sobr elsoa ctviso ROA: return
on assets.) es una emdiad de la utilida
por dolar de activos
ROA= UN/activos totales
10.12%
ROA es neutra con respecto a la
estructura de capital(interese
apfgados) e impeusto
= EBIT/AT,
Ej 691/3588= 19.3%
Si 19.3% es es > tasa de endeudameinto.
La empresa gganra mas dienro sobre sus
inversiones que lo que pagara a sus
acreedores de equity o deuda.
4. Rendiemnto sobr ele capital.
ROE, sirve para emdir ocmo les feu a lsoa
ccionsitas dirante el ao.La meta es
beenficar a lsoa ccionsitas, ROE es en el
aspecto contable, la verdadera mediad del
desmeo en trminos del reglon de
resutlados.
ROE: UN/equity total
Ej 14%, por lo tanto por cada doalr de
capital invertido este genera 14
centabos de utilidad,es correcto en
temrinos contables.
ROE y ROA son tasa de rnedimeinto
contable. Sobr ele valor neto invenrtido.
Rdneimdento sobre lsoa ctivo en libro y
rendiemnto sobre el capital neto en libros.
-es inapropidado comprara el resutlado con
una tasa de ienteres observada en el
mercado.
ROE>ROA, rfelja que el se ha ehcho uso
del apalncameinto.
MEdidad e valor de Mercado(5)
Esta info no ncesarmiente contienn los
EEFF: prico de mercado por accin. Solo
s epeuden usar apra cciones que cotizan
ene la Bolsa.-outstanding
-si una empresa tien 33 millons de
acciones en ceiruclaicon y cada una vale
88 doalres.UN 363
1. EPS= Net income-dividends on
preferred stock/averrgage oustanding
shares:
=362/33= 11
It is the portion of a compny profit alloated
to each osutanding shre of commo stocl. It
serves as an indicator of a compnays
profitability
Ehrn laculating it is more accurate to use a
weighted average numbers of shares
outstanding over the reporting them,
because the number of share outstanding
can change over time. But to simplify you
can use N share of oustanding at the end of
the period.
It is considered to be the single most
importantn variable in detemrininig a shars
Price. It is also a major component sed to
claculate th Price-to.earingins valution ratio
Ej: if th ecompnay pays a NI= 25, if the
copnay pays out 1 in prferred dividends and
has 10 shares for half of the year and 15
shares for the other half, the EPS would be
24/(10+15/2= 12.5, fir the 1 of preferred
divnidnes is deducted from the NI to get 24,
then the weighted avergae is taken to ind
the number of shares
outstanding(50%*10+50%*25=12.5)
An important aspect of EPS thas often
ignored the capital thai s required to
generate the earings(NI) in the claculation.
Two compnaies could generate the same EPS
number but one could do so with less
eqeuity(investment) thath cmpnay wol be
more eficiente at using its capital to
generate income and it woul be a better
compnay.
2. Ratio P/E: la priemra de las medaida de
valor de maercado, la razono mltiplo
precio a utildiade o P/U:
P/E= Preico por accin/ utildiade x accin=
88/11= 8veces.
Se puede decir que las acciones de la
empresa se venden a razn de 8 veces
su utilidad, un mltiplo de 8.
-mide la cantidad a prgar de
invenrsionsitas pro cada doalr de
utilidad actles de la empresa
-si es alto tien buenas perspectivas de
criento fturo.
- o tmabien que no tien buenas utlidades.
3. Razn de valor de mercado a valor en
libros:
Razn a valor de mercado a valor en
libros= valor de mercado x accin/ valor
en libros x accin.
-el valor en libros x acion es el capital total( y
no solo el capital comn) dividido entre
numeor de acciones en ciruclaicon
Ej 88/78.5(2591:equity/33)=1.12 veces
El valor en libro x accin refleja costos
histricos. Comrpara el valor de mercado
de las inversiones de la empresa con su
csoto.
Si es z1 siginifaria que la empresa no ha
logrado genera valor apra sus aciconiestas.
4. Capitaliziacon de mercado.
La cpaitlaiziaocn de mercado de una
empresa que cotiza en bolsa es = preico de
mercado x accin X el N de acciones en
ciruclacion.
Capitalizaicon de merado=Precio por
accin x acciones en ciruclacion=
88*33= 2904
U comrpador debera ogfrecer pro lo menos
2904 millones + una prima.
5. Valor de la empresa:
Tien relacin estrecacha con capitalziaicon
de mercado.
-En lugar de centrase en el vlaro de mercado
de als acciones en circulacin.
-tmabine las razones como P/U si se tine
oporutnidadede crimiento tnega mltiplos
VE altos
El vlaor de la empresa es 3.6 veces l
autilidad oeprativa. Es decir se
neceistran 3.6 aos de EBITDA con tal
valor para alcanzar a cobrar el valor de
la empresa en ese momento

Valor de mepresa = valor de mercado de

las acciones en ciruclacion + valor de
mercado la deuda en circulaicon que
devenga inters - el fectvio de caja.
-Se conce la capitalizaicon de mercado de la
empresa
Pero no el valor de emrecado de la deuda
en ciruclaicon que devenga inters.
Por eso se usa el vlaor en libros de la
deuda en circualcion que devenga
inters efectivo de caja.
El vlaor de la empresa= Capitlaiziaocn de
mercado+ vlaor de mercado de lad euda que
devenga inters-efectivo
= 2904+ (196+)457)-98= 3459
Se mide le VE para clacular mejor cuanto
se encesita par aocmrpa todas als
acciones en circualcion de lae mrpesa y
liqudiar la deuda. El ajsute por e el
efctivo e sapra reconcer que un posible
comrpado usara de inmendito el fectivo
existnente apr recompras la deuda o
pagar un dividendo.
Multiplos del vlaro de la empresa.
Se usan basados en el VE cunado la meta es
estimar el vlaor del engocio totla y no
centrase exclusivmaente en el vlaor de
su capital.
Par aun mltiplo aproiado el VE/EBITDA:
=3469/967= 3.6
Permite comparar con otr empresa
cunado exsiten difrencias en al
estrucutra de capital(gastos en inters,
impuestos o gastos de capital. Estas no
afectan directamtne el mltiplo.

Identidad Du Pont
La diferencia entre estas emdiada de
rentbailidad ROA y el ROE refleja el uso del
financiamiento con deuda o
apalancamiento financiero. Formas de
descomponer el ROE en sus partes
componentes.
ROE: Rendimiento sobre el capital= Utilidad
neta/ Capital total
Si fuese necesario, se podra multiplicar esta
razn por Activos/Activos sin cambiar nada:
ROE= UN/Capital total
=Utilidad neta/Capital total x Activos/Activos
= Utilidad neta/Activos x Activos/
Capital total
- se ha expresado el ROE como el producto
de otras dos razones: el ROA y el
multiplicador del capital:
ROE = ROA x Multiplicador del capital=
=ROA x (1 + razn de deuda a capital)
De regreso al caso de Prufrock, por ejemplo,
se puede observar que la
-Razn de deuda/ capital =0 .39 y ROA=
10.12%.
-ROE de Prufrock, como ya se calcul, es de:
ROE=10.12% x 1.39= 14%
La diferencia entre ROE y ROA puede ser
sustancial, en particular en el caso de
ciertos negocios. Por ejemplo, basndose en
estados financieros recientes, U.S. Bancorp
tiene un ROA de slo 1.11%, lo que en
realidad es muy tpico de este tipo de
institucin financiera. Sin embargo, los
bancos tienden a solicitar en prstamo
grandes cantidades de dinero y, como
resultado, tienen multiplicadores de
capital relativamente grandes.
En el caso de U.S. Bancorp, el ROE es de
casi 11.2%, lo cual implica un multiplicador
del capital de 10.1.
- Se puede descomponer an ms el ROE
multiplicando la parte superior y la parte
inferior por las ventas totales:
-ROE= Ventas/Ventas X UN/Activos X
Activos/Capital total
Si se reordenan las cosas un poco, el ROE es:
ROE =UN/ Ventas X Ventas/Activos X
Activos/ Capital total
Los dos primeros son ROA, luego
Identidad Du pont
ROE= margen de utilidad * ROA
*Mulitplicado de capital:1+razon de
deuda capita
Para verificar la relaicon:
15.7%X0.64X1.39=14%
DUPONT identifica que 2 factores afectan el
ROE.
1. La eficiencia en las operaciones
(como se mide por el margen de
utilidad).
2. La eficiencia en el uso de los activos
(como se mide por la rotacin de los
activos totales).
3. El apalancamiento financiero
(como se mide por el multiplicador
del capital).
-La debilidad de la eficiencia en las
operaciones o en el uso de los activos se
reflejar en una disminucin del rendimiento
sobre los activos, lo que se traducir en un
ROE ms bajo.
-De acuerdo con la identidad Du Pont,el ROE
podra elevarse con un incremento del
monto de la deuda de la empresa. Sin
embargo, hay que tener en cuenta que
aumentar la deuda tambin incrementa
los gastos de intereses, lo cual reduce
los mrgenes de utilidad y esto merma
el ROE.
-Por lo tanto, el ROE podra aumentar o
disminuir, dependiendo de las circunstancias.
Lo importante es que el uso del
financiamiento con deuda tiene algunos
otros efectos y, como lo expondremos
con mayor detalle en captulos posteriores,
la poltica de estructura de capital de
una empresa determina el monto de
apalancamiento que sta utiliza.
-La descomposicin del ROE que se ha
analizado en esta seccin es una forma
conveniente de enfocar sistemticamente
el anlisis de estados financieros. Si el
ROE es insatisfactorio de acuerdo con
alguna medida, la identidad Du Pont
indica dnde se deben empezar a buscar
las razones
Yahoo tenia un ROE paso de 10% a 6.9%,
Google pso de 17.7% a 18.6%. porque
google fue mayor y porque yahoor cayo?
El margen de utilidad ed yahoo cayo
drasticment de 16.4 a 9.5%. el margen de
gogol due de 25.3% igual cosntnate.
Tinen simialres rtoaicon de activos y
apalncameinto.
Las efeicnciai de operaicon peuden deberse
a volumens mas grande, preicos mas
altos o costos mas bajos. Por tanto la
diferencia de ROEs es debido la margend
eutilidad.
Problemas con el anlisis de estados
financieros
1)el problema bsico con el anlisis de
estados financieros es que no existe una
teora fundamental que ayude a
identificar cules son las cantidades
que se deben examinar y que permita
establecer puntos de referencia o
comparacin. Solo apicarlocgica
eoncmic y teora infiancierapara
elaborar juicios acerca del valor y el riesgo.-
puede determinar qu razones son
ms importantes y cul podra ser un
valor alto o bajo.
2)otro problema en especial grave es que
muchas empresas son conglomerados,
que tienen lneas de negocios no
relacionadas en mayor o menor medida.
GM es un ejemplo bien conocido. Los estados
financieros consolidados de tales
empresas no encajan en ninguna
categora clara de la industria.
Annalsisi de EEFF til-cuando es la
misma lnea de negocios, la industria es
competitiva y existe slo una forma de
operar.
3)Es que los principales competidores y
los miembros naturales de grupos
similares que operan en una industria
pueden estar dispersos por el mundo.
problema radica en que los estados
financieros de las filiales extranjeras
(en relacin con Estados Unidos) no
necesariamente se ajustan a los
principios de contabilidad en general
aceptado(GAAP)s. La existencia de
distintos procedimientos y normas
dificulta la comparacin de los estados
financieros entre empresas de diferentes
pases.
4)Incluso las compaas que se
encuentran claramente en la misma
lnea de negocios pueden no ser
comparables. Por ejemplo, las empresas
de electricidad que sobre todo se
dedican a la generacin de energa se
clasifican en el mismo grupo. Con
frecuencia se piensa que este grupo es ms
o menos homogneo. Sin embargo, la
mayora de las firmas de electricidad
operan como monopolios regulados y,
por lo tanto, no compiten entre s, por lo
menos no histricamente. Muchas de ellas
tienen accionistas, y muchas estn
organizadas como cooperativas sin
accionistas. Hay diversas formas de
generar energa, las cuales van desde
plantas hidroelctricas hasta plantas
nucleares, por lo que sus actividades
operativas pueden diferir mucho.
5)el ambiente de regulacin afecta en
gran medida la rentabilidad y, en
consecuencia, las compaas de
electricidad que operan en diferentes
localidades pueden ser similares, pero
registran distintas utilidades. Primero,
distintas empresas usan diferentes
procedimientos contables; por ejemplo,
para el inventario. Esto hace difcil comparar
los estados financieros.
6)Segundo, diferentes empresas terminan
sus ejercicios fiscales anuales en
diferentes momentos. En el caso de las
empresas en industrias estacionales
(como un minorista con una temporada
navidea prolongada), esto puede
ocasionar dificultades en la comparacin de
los balances generales debido a las
fluctuaciones que muestran las cuentas
durante el ao.
7)Por ltimo, en el caso de cualquier
empresa, la presencia de acontecimientos
inusuales o transitorios, como una
utilidad que se obtiene una sola vez
como resultado de la venta de un activo,
puede afectar el desempeo financiero.
Tales acontecimientos pueden enviar seales
engaosas cuando se comparan empresas.
Liquidity ratios:
1) Current ratio: AC/CL
2) Quick ratio=( Cash Y eqeuivalents+market
secuirties+accounts recivables)./CL
=(AC- Exsitencias-Gastos pagados x
adelantado-Prestamso a accionsitas)/CL
3) Cash ratio= (cashY eqeuivalentes+market
secuirties)/CL
Management ratios
1)Receivable turn over(rotaicon de CXC)
= net sales/average accounts
recivables(CXC):average of the last 2 years (t
y t-1)
2) Inventories Turnover: COGS(csotos de
ventas)/Average inventories( t y t-1)
3)working capital turnover: net
sales/Average Working Capital:
=PROMEDIO(AC(t)-CL(t), AC(t-1)-CL(t-1)
4)fixed assets turnover(rotaicon AF): Net
Sales/ Average Fixed asset(promedio de
AT(t)-AC(t) y AT(t-1)-AC(t-1)
5) Payable Turnover(rotaicon de CXP):
Purchases /Average accounts payable
Compras:CV+ exsitencias t- existencias t-1
-Days of sales outstanding: 365/ Receivable
turn over
-Days of inventories on hand: 365/
Inventories Turnover
-Days of payable: 365/ Payable Turnover
-Cash Conversion Cycle: Days of sales
outstanding+ Days of inventories on hand-
Days of payable
Solvency Ratios
1)Financial Independence: Liability/Asset
2)Long Term Autonomy: (Non current liability
+ equity)/Asset
3) Equity Leverage: Liability/Equity:PN total
Profitability Ratios
1)COGS(Margin inverso) : COGS/Net Sales
2) Operating Expenses: Operating
expenses/Net Sales
3)COGS + financial and operating
expenses: (COGS + financial and operating
expenses)/Net Sales
=-Costo de ventas-Gastos en investigacion-
gastos admisnitrativos y de ventas+ total de
otrso ingresios o gastos netos + impuestos
4)ROE (Return on Equity) : Net Income /
Average equity(promedio de PN hoy y ayer)
5) ROA (Return on Assets): Net Income /
Average assets(proemdio de activos ghoy y
ayer)
Debt Ratios
1)Short term debt to Equity: Short term
debt(deudas de cortp palzo o teudas de alrgo
palzo Corrientes + otros deudas Corrientes)/
Equity(PN hoy)
2) Interest Coverage: Operating profit
(EBIT):ingreso oeprativo/ Interest payment
Estado de flujo o fondo:
Dterminar diferencias entre saldos de 2 BG
Cta:(Monto de hoy monto de ayer), Z
fuentes= Zuso
Activo: si es >0 es uso , <0 fuente
Pasivo Patrimonio: si es >0, fuente, <0
uso
Cuentazas
1) Permanent Resources: are all the types of
LT finantial sources No CL+Equity
2) Spontaneous liabilities: are all the short
teerm finantial
sorucesimpuestos+cts+Accounts
Payable+Other Current Liabilities
3)Financial current liabilities: Short/Current
Long Term Debt(CL)
4) Working capital: Total Current Assets -
Total Current Liabilities + Cash And Cash
Equivalents
5)Working capital requirements(NOF): =
Financial current liabilities +Working capital
=CL+tota current assets-total current
liabilities+cas and cash equivalents
Flujo de caja libre:
It is the cash of free use for creditors and
shareholders it is a profitability
Luego de costear:
-Gastos operativa, K/L , Gasto de k de
LP
Triple identidad + FCL que son recibidos
par aacionistas para que +mas gente
demndade acciones por las buenas
utilidad+ el valor de la accin
aumenta mediante subida del P accin
+ dividendos.
Free cash flow:
Cash flow identity
Compras= IF-II+CV
-FCF(flujod e caja operativo)=CFC+FCO
1)FCFF = EBIT(1-t) + deprecia+
amortization-%K/L operativo(NOWC)-
CAPEX(LT investmemnt)
NOPAT (net operating profit - adjusted taxes)
NOPAT=EBIT(1-t)
2) EBIT=ventas-costo de ventas-depreciacion
t=T/EBIT: unlevered tax rate
3) %NOWC(K/L)=%CA-%CL operative
(change in necesidaddes ioeprativas de
K/L)=cambios en actvios corrientes-
cambios en pasivos oeprativos
corrientes
4)CAPEX=%NFA(activos fijos netos)-
depreci(gasto de capital)
VE=VL=D+E
1) Pasivos corrientes=PC operativos+PC
financieros
2) EQUITY=Capital social+ utilidades
retenidas
3) DEBT=pasivos corrientes+ deuda de LP
-PC operativo: son los no negociados y no
generan interese, osea no hayh necedisda de
negociar con nadaie, simplemente vendo
mas y lo obtengo. Ej: compra de MP, una
cta x pagar, ir x pagar, remuneracionesx
pagar
-CAPEX: inversiones a LP para crecimiento
de la empresa.
Anlisis y diagnositico financiero pronostico
del futuro
NOWC=C/A-C/Loperativo necesidad
operativa de K/L
NWC= C/A-C/L necesidad de K/L
contable
EFN(neceisdade externas de financiameinto)
EFN=C/Lfinancimeinto+LTD+C/S=NOFa
re all the kinds of fianicila soruces in
short term and long temr
Dinero para poder opera res externo y tien
un cosnto :r
Aumento de k tmabien
-los dividndendo no van porque no generan
un costo.
-si tiens garna poder de negociaicon
K/L<0no es nula
-Si tiens CLoperativa=80, CL fina=20, AC:80,
eres ilquido pero rentable.
- Si tiens CLoperativa=20, CL fina=80,
AC:80, eres ilquido y menos rentable y
aque debes inters financiamiento que no
hay en l priemro
-es mejor ser mas rentable que ilquido
porque pudeo cubrir las gnanacias las
deusas de CPlazo
1)cuentas importantrs: ananilissi
vertical
2)evolucin de ctas tiempo: anlisis
hpriznotal
Para detectar ptrones, si por jemeplo si se
endeuda sistemticamente a CP con letras x
pagar. Se esta obteniendo renbtialdiad para
cubrirse fondos.
3) elaboraicon del estado de fuentes y
usos: de donde obtengo la palta y
donde la estoy invirtiendo.
Partida de flujo: pertence a 1 ao
Aprtida de stock: saldo al momento
ROE: NI/equity: NI:flujo, equity: stock
-Para eso se debe hallar un promeido o el
flujo en la fecha
Si el activo aumenta estoy invirtiendo en el
Si apsivo aumenta es una fuente
Si pasivo caeuso de fondos
Ratios de deuda: D/VL, E/VL,D/E
Conversin de cash: desde cuando pagas en
eefectivo hasta que vendes el producto.
KL(-): siginifaca quie neceisto menos dienro
apr acubri mis operaciones.
KL(+)significa que se encesita mas dienro
para operar
1) K/L neto operativo : es el dienro extra de
CP que tine in costo financiero y que
necesito conseguir para operar. Ej:
prestmao paga interese.Pago inters cada
vez que hay. Es decir al restar los
operativos que son pasivos sin costo me
estara quedadno justo cons los activos
por curbir que si deben financeiarse con
cost financiero
-K/Lneto oeprativo=C/A-C/L operativo
2) K/L neto financiero: el pasivo corriente
son csoto que encesito cosneguir
K/Lneto oeprativo=C/A-C/L fiananciero
3) K/L neto (NWC)=C/A-C/L=RP-ANoC
4) CL= C/Loperativo++C/L finaciero
NWC=C/A-C/L
NWC=C/A-(C/Loper+C/L+finaci)
NOWC=C/A-C/L opera
NFWC=C/A-C/L financ
5) NOF: NOWC + NFWC-C/A
NOF: dinero de CP para operar sin costo
K/L total: toda dinero de CP que necesito
para operar y que puede tener un costo.
6)Necsidad externas de
fienaiceinto(EFN):recursos de CP y LP que
tine un csoto de finainceimitno para la
compaa y que se
neceist apar
aoeprar.para cubrir
necesidade de CP.
Luego de usar recrusos
propios y pasivos
espontaneos sigue EFN.
---Equity=C/S+R/E---- NI-
DIV=R/ENI: Utili Net
EFN= %C/L financial
+LTD+% C/S
EFN>0 se encesitan recursoso.
La deuda de LP es mas cotosa que CP
Emsision de acciones es costosa porque
le volumen negociado debe ser grande,
para adqueir un bune monto de capital.
Emitir bonos e smas fcil
El costo financiero es mayor en acciones
que bonos.
(menos costoso) Deuda de cpluego Si AnoC= sube 10%- cuanto debe
deuda de LPEmsision deacciones (mas aumentar de extrea debo conseguri.
costoso)
% ventas= S1- S0/S0 = tasa crcimeinto de
El ratio de apalcnacimeinto dinanceiro no ventas
debe ser >40%
Solo se puede usar si es planificacndo el
Rario de liquidez>1 futuro, se requieren muchos supuestos, se
usa solo cuando se tienen cunetas del
Planificaicon financiera de LP Balance general.Es aplciabel a una empresa
Obejtivo de una comaia es crecer. La que ya opera el mtodo de ventas se aplcia a
ceustion si quiere crecr % ventas tengo al empresas neuvas.
capacidad? M:profit margin, M=NI/S, D:dividend pay out,
Si neceisto AF? No d=DIV/NI

Activo Espontaneo: toda inversin que 1=b+d, b: retention ratio, g:% de ventas ,
aumenta con el crimiento de ventas. NI= S1 * M

1)mtodo de % EFN: Div= d NI

Tengo los fondos par apoder lograr el -EF=RN+PN+NCL-RE

auemnto el prximo ao?
% en EFN de finaicneimitno= financimeinto
de LP
%EFN=%C/L financ +% LTD + %C/S
Costos: plug, se define cuanto de deuda de
LP o de gfondo se encesita,restricciones de
rentbaiilidad
-EFN= C/L finan +LTD + C/S
%EFN=%C/L financ +% LTD + %C/S
-% EFN = A* (% Sales)- C/L operativo(como
CXP) (R/E)
-% EFN = A* (% Sales)- C/L operativo (NI-
DIV) Todo lo que necesito conseguir- Lo que
no necesito
-% EFN = A* (% Sales)- C/L operativo S2007 S2006 1 g 1200 1.25 1500
E(S)M(1-d)
vetas
-%EFN= A* (% S)- C/L operativo(%S) proeyctadas
S0(1+g)M(1-d)
Nivel de ventas 100% capcidad= 1200
%EFN= A* (% S)- C/L operativo(%S) Si las Vtas PY: ventas*(1+g) > nivel ventas 100%-
S0(1+g)NI/S(b) usar ventas py sobre vtas 100% capacidad
%EFN=A*(g) C/L oper (g) (s1)M(b) Next, we apply the formula of the EFN: PM=
%EFN=A*(g) C/L oper (g) (1+g)NI(b) NI/sales

S2007 S2006 1 g 1200 1.25 1500 EFN

A*o
S1 - So -
L*o
S1 - So - PM S1
So So
Next, we apply the formula of the EFN:
* *
A L
EFN o
S1 - So - o
S1 - So - PM S1 (b)
So So
2000 400
180
EFN 1500 1200 1500 1200 15
1200 1200
1200
% 60 de capacidad: Sales/ % actual capcidtiy
= total capacity 1.1Suppose the firm is operating at only 60%
capacity in 2006. What is EFN now?
La diferencia con el metodo de %ventas este Answer: capacidad=60%, g=25%, Sales: 1200,
asimen:D, b, M NI= 180, b= 126/180, total assets= 2000, CA=
1200, CLO= 400 EFN=?
PM= NI/CA
First, one must estimate the level of sales at full
-El etodo de las ventas permite hacer crecr
operaciones financieras, es decir cual es la S FC
estreategia financeira par acosnefuir iun capacity ( ):
nivel minimo d eliquidea y solvencia.
S0
-Adquirir fondos de endudameitno para un S FC
% Capacity
nivel de rentbaildiad dadopicking order
-Quiero un nivel de endeudameino par Si las Vtas PY: ventas*(1+g):1500 < ventas 100%
aunnivel de rentbailidad en el tiempo, capacidad:2000 usar vtas py sobre ventas a 60%
moving target de capacidad, no hay necesidad de aumentar AF
-Si trabajo a plena capacidad A*=AT pero si comprar nuevos activos corrientes

-si no trbajo a plena capacidadA* = AC 1200

S FC 2000
0.6
n/a son cuentas de cruadre=cuentas plug
1.If the firm is operating at full capacity and no new Como nivel de vtas py: 1200*(1+g):1500 < vtas
debt or equity is issued, what is the external 100% capacidad usar 1500
financing needed (EFN) to support a 25% growth
rate in sales? Lo nico que debemos considerar en EFN es que
Answer: 100% capcidad g=25% EFN=? A*=CA (porque no hay necesidad de aumentar AF)
1200 400
180 126
First, we estimate projected sales for the next year: EFN 1500 1200 1500 1200 1500 42.5
1200 1200
1200 180

1.Suppose the firm is operating at 90% capacity in

2006. What is EFN now?
 Answer: Cuando una sociedad realiza una ampliacin de
The sales at level of full capacity are: capital, los accionistas antiguos tienen derecho de
suscripcin preferente.
1200
S FC 1333.33
0.9
Clasificacin por pago[editar]
Como vtas py(1500)> vtas 100%
capacidad(1333.33) EFN are estimated with a El precio que deben pagar los suscriptores por cada
two-step procedure: accin nueva es determinado por la sociedad,

A. We estimate the EFN to reach full capacity clasificndose:

sales: vtas 100% capacidad sobre vtas a 90%
capacidad A la par: El precio pagado es el mismo que el
nominal del ttulo.
1200 400 180 126
EFN 1333.33 1200 1333.33 1200 1333.33 51.1 Por encima de la par: El precio pagado es
1200 1200 1200 180 superior al nominal del ttulo.

Liberada: La ampliacin se realiza con cargo

B. Then we estimate the EFN to reach a reservas de la sociedad. Cuando es totalmente
forecasted sales from full capacity sales- liberada se dice que es 100 % liberada y sta es
vtas proyectadas sobre vtas 100%
totalmente gratuita para los accionistas que
capacidad NFA= CL
obtienen nuevas acciones sin tener que aportar
CA o NFA o L*
EFN S1 - SFC - o S1 - SFC - PM S1 - SFC dinero.
(b) Esparcialmente liberada cuando el cargo
S
o SFC So
lo paga una parte las reservas de la sociedad y
otra parte el suscriptor, viene expresado en %.

1200 800 400 180 126 uando una sociedad ampla su capital segn
EFN 1500 1333 .33 1500 1333 .33 1500 1333 .33 193 .60 el primer sistema (a la par), aumenta el nmero
1200 1333 .33 1200 1200 180
de acciones en circulacin, lo que hace que
Hence, the total EFN are: disminuya el valor contable de cada ttulo (la
empresa vale lo mismo pero se divide entre ms
EFN 51 .1 193 .60 142 .6
ttulos). Este hecho se conoce como efecto
dilucin. Para evitar este efecto, es por lo que se
suele exigir una prima de emisin, de manera que
Ampliacin de capital los nuevos accionistas paguen tambin por las
reservas de la empresa, y la valoracin de
Ampliacin de capital es el incremento del capital empresas de nueva creacin, donde son las
socialde una sociedad. Se realiza emitiendo perspectivas de beneficios futuros las claves de
nuevas acciones o aumentando el valor las que tambin, pasan a ser propietarios.
nominal de las ya existentes. El efecto contrario
Valoracin Pre-money y Valoracin
de ampliacin de capital sera la reduccin de
Post-Money
capital. Las acciones nuevas pueden tener iguales o
diferentes derechos econmicos que las antiguas.
Cuando el inversor ha decidido invertir una cantidad
en una empresa, esta cantidad representar un
porcentaje en el capital social, dependiendo de la
valoracin pre-money que hayan acordado
negociado el antiguo accionista y el inversor. La
valoracin Pre-money es la valoracin que se le ha
otorgado a la empresa por su actividad en el mercado
desde su constitucin, previamente a la recepcin de
la inversin y esta valoracin es independiente al
capital social de la empresa.
La valoracin Post-money es la valoracin que se le
otorga a la empresa posteriormente a la aportacin
de la inversin.
Por ejemplo si un inversor invierte 100.000 a
cambio del 20% de una empresa, el valor Post-Money
ser 500.000 (100.000/20%). El valor Pre-Money
ser de 400.000, es decir 500.000 menos los 100.000
que se invirtieron en la empresa
A continuacin realizaremos un simulacro
ampliacin de capital siguiendo los conceptos
anteriormente expuestos, Caso Prctico completo
para ese mismo supuesto con un capital inicial de
3.000 en participaciones de 1 y un inversor de
100.000 :
El inversor asumir la titularidad de 750
y participaciones de la Sociedad, que representarn un
20% del total de las participaciones sociales en las
que estar dividido el capital social, es decir, 3.750
participaciones.
Es aqu donde entra en juego la Prima de emisin, ya
que si cada participacin tiene un valor de UN EURO,
al realizar la ampliacin de capital el inversor slo
estara aportando 750 Euros, faltara aportar los
99.250 Euros restantes de la inversin. Esta cantidad
(99.250 Euros) ser aportada por el inversor a la
Sociedad mediante una Prima de emisin que
contablemente figurar en el pasivo de la compaa
como fondos propios, pero no como porcentaje de
capital. Es decir, el inversor pagar por cada nueva
participacin emitida UN EURO ms una prima de
emisin por un valor total de 99.250 Euros,
adquiriendo el inversor la condicin de socio de la
de
empresa con un porcentaje del 20% en el capital
social de la misma. El asiento contable de la
operacin ser: 100.000 Tesorera a Capital 750 y a
Prima de Emisin 99.250
A la par

Un equipo emprendedor con una Sociedad Limitada Una sociedad ampla su capital realizando
con capital social de 3.000 Euros, representados en una ampliacin a la par de la siguiente manera:
3.000 participaciones de un (1) Euro de valor nominal
cada una, despus de varias reuniones y a) 1 accin nueva a la par por cada 4 acciones
negociaciones, logra que un Business Angel acceda a antiguas (1x4 a la par).
invertir 100.000 Euros a cambio de un 20% del capital
de su Startup. b) Las acciones de la sociedad tienen un valor
nominal de 3 euros.
Por tanto, la Junta General de Socios deber acordar
la ampliacin del capital social de la empresa, Un accionista antiguo que tenga 20 acciones puede
emitiendo nuevas participaciones que representen el acudir a la ampliacin y suscribir un nmero entero de
20% del total de participaciones existentes una vez ttulos. Para acudir a la ampliacin deber hacer
producida la ampliacin. grupos de 4 acciones antiguas y por cada grupo
recibir una accin nueva. Si posee 20 acciones har
En este caso, el nmero de participaciones a emitir es 5 grupos (20/4 = 5) y tendr derecho a suscribir 5
de 750 nuevas participaciones. acciones nuevas. Por lo tanto el accionista que tenga
750/(750+3.000)=20% 20 acciones antiguas y acuda a la ampliacin tendr
 o confirm your intention to participate, please Reply to this
20 ttulos antiguos ms 5 ttulos nuevos que
email with a current copy of your resume and a 5 slide
desembolsar por cada uno de ellos el valor nominal, presentation with the following casebefore Friday 9th of
December 1pm.
en este caso 3 euros, siendo:
Case: A group of foreign investors have decided to diversify
A x N = Nmero de ttulos nuevos adquiridos x Valor their portfolio by investing in Latin American, and are
therefore considering on acquiring part of Cementos
Nominal de cada accin = 5 x 3 = 15 euros. Pacasmayos common stocks. Your job is to create a 5 slide
presentation with a brief introduction of the company, an
outlook and analysis of the industry (including possible risks
Totalmente liberada (liberada 100x100) and mitigants) and your final recommendation.
Note: The presentation must be done in English and there
is no predetermined structure for the presentation.
Una sociedad amplia su capital realizando
una ampliacin totalmente liberada de la siguiente
CAPM PERU y AL
manera:
-Beta de bloomber: entre la accion o
a) 1 accin nueva totalmente gratuita por cada 5 portafolio con el emrcado.
antiguas (1x5 liberada 100x100). Tasa libre de riesgo (RF):retornos de
bonos soberanos del pas en soles o
Un accionista antiguo que tenga 50 acciones puede deolares.
acudir a la ampliacin y suscribir un nmero entero de Sin embarognocmo en el emrcado
ttulos. Para acudir a la ampliacin deber hacer internacional peru tiene califiaicon BBB+ no
grupos de 5 acciones antiguas y por cada grupo corresponde usarla como libre riegso sino
recibir una accin nueva. Si posee 50 acciones har mas bien los bonos del tesoro americano a
10 aos para invesrionistas internacionales,
10 grupos (50/5 = 10) y tendr derecho a suscribir 10
pero esta libre de riesgo no recoge: 2 partes
acciones nuevas. Por lo tanto el accionista que tenga
-prima x riesgo pas=2% en peru
50 acciones antiguas y acuda a la ampliacin tendr
50 ttulos antiguos ms 10 ttulos nuevos sin -prima por riesgos cambiario
desembolso para el suscriptor. Existiendo coreelaicon entre ambas
Solucin: agregar a al rf usa de bonos del +
A x 0 = Nmero de ttulos nuevos adquiridos x 0 = 10
country risk premiun
x 0 = 0 euros
But in practice this assumes that the
Los resultados de la empresas diference between soverieng risk = country
risk prmiun which is not correct.
eubicaronenlneaconnuestrosestimados,dadoque:i)noesperbamosmayorescambiosenlosingresos,debid
ventasadicionalesqueserealizaronenel3T2015paratrabajosdeprevencincontraelFenmenodelNio;y,ii)
SoRF to invest in peru= global soverign
ipamosunamejoraenelmargenEBITDA,debidoalasmayoreseficienciasquegeneralanueva
bonds it contents currency risk and planta
specificde Piura
risk of our market that are not diversified
internationally.
La utilidad neta tuvo un retroceso de 20.9% A/A. A pesar de la mejora en el margen EBITDA (33.2% v
31.8% en el 3T2015), BETa:
tuvieronunmayorimpactoenlacompaaladepreciacinadicionaldelaplantadePiura,ylaausenciadecapital
The principal problem wit emerging market is
ndeintereses, dada la finalizacin de la construccin de la we
is that misma.
dont count with the avlaibale
information for profitability or rate of return
Market Cap vs Enterprise Value | fo the market.
Solution: takes betas from other markets
Same or Different? USA, assuming the tha corraltion with the
market comes from the similar bunises
structure.
The beta <1, indicetae the firm is less
sesnsible with changes in the market,
inelastic
Prima de riesgo del mercado
Ther is also non rleiable infromation about a
proxy of the market bwecause th
ebchamarks of the market are conetraed in
som sectors as mining, real stae rinfratrur.
Solution: rmarket risk prmiu of USA. But this
primes doens take into account riskes
derived from intitituonal differences, laws
infreastruct lakness, security and many
aspectos that afecct the risk uin a emerging
country.
-market risk prime* voalitty local market
BVL/volatility Usa market(VIX)
Some authors propose affects this estimate
by multiplying for som factors less than 1 like
0.6.
E(R) = Rf peru+ Bapalcado de usa(marke
prime riskusa)*voaltility peru/voaltilit usa
COMPONENTES DEL CAPM
Inversionistas son personas aversas al
riesgo.
Se debe de cuidar el balance entre el
retorno esperado y su varianza asociada.
Existe una tasa libre de riesgo para invertir
o endeudarse.
No existe asimetra de informacin.
Inversionistas son racionales sobre las
conclusiones que tomaran acerca de los
retornos esperados y la desviacin estndar.
a. Rendimiento Libre de Riesgo (Rf)1
it is recommeded to use T-bills due to more
longer terms wont allow to estimate with
precision the iflation as los as the interes rate
movements so in this sitaucion thwre will be
motre riskes.
As an average of the return of 3 months
1928-2010
b. Rendimiento de Mercado (Rm)
cosndier S& 500 are the 500 companies that
list in New yorek sexchange and American
exchange (amex) and nasfdaq
this index it is contruct as a with average of
stocks with maket value for each comapny .
it is important take in consideration an
invement horizon of long term, because the
current economic rerturns{(market return+
rf) do not affect the costo of capital.
As an average return of S& p 500 1928-2010
c. Beta ()
it is the sensitiveness of the security to the
non diversifed risk knows as market risk or
sistematic risk.
Betas>1 implies that the security has more
risk than the average of the market
So securities with larger betas will be
desciount with higer rates as way
compensated to the investors for asuminr
risk over the market.
Betas of the sector real state , fianancial
Ways to calculate beta:
1) With a regression betewnwn the
retrurns of the scruty and the reruns of
the market
2) R squered= squeare of crorelacio
coeffcitne
3) Covariance and variance
d. Country risk primiun
It is the risk of a investment deut to
escpecifc factors and common to a country. It
can be cosndiere as an averages iris of
invesments mede in a country. Measure the
porltic , economic, public security of a
country.
It assumes that it is relatared to some events
thath a sovering state could cross in temr of
sovering default
Average of the indicator of Jp morgan
embi+peru (2008-2012)
Estimation of diconte rates in
emergengin markets
Divide in 2:
1)For well diversigie investors(WDI)
2)no well-diversified investors (NWDI)

3) Models of partial integration

Mariscal and Lee or Goldman Sachss
Discount Rate

Model (1993):

Degree of diversification
0 Max
Total Risk Systematic Risk

What matters is to estimate the value

of the project as it were traded 4) Lessards Model (1996)
(quoted) in the capital market
The key variable is the degree of
integration of the EM (country risk is
being used as the degree of
integration
I) Discount rates for Well-
Diversified Investors (WDI)
BUS,i: secruities beta whti respecto to the
Three models:
usa market
-total segmentation (Local CAPM),
Estradas D-CAPM Model (2002)
-total integration (World CAPM)
-models of partial integration:
Mariscal and Lee (1993), Lessard
(1996), Damodaran (1999), Estrada
(2002) and Bodnar, Dumas and
Marston (2003).
1) Model of total segmentation
Local CAPM (Sharpe, 1964)

Bodnar, Dumas y Marstons Model or

Hybrid Model (2003)

Risk premiun
2) Model of complete integration
Damodarans Model (2002, 2003)
World CAPM (Solnik, 1974)

II) Discount rates for Non-well-
Diversified Investors (NWDI).
Again, what matters is to estimate de
value of the project as it were traded
(quoted) in the capital market.
In EM the estimation of betas still
contain specific risk for each asset due
to the lack of market transparency.
Hence, one must consider that the
estimation of betas in fact also
involve specific risk.
Damodaran (2002) suggested the
following adjusment for betas to
include this fact (total beta):
i for private firms: The Pure Play
i i,M i i iT
M M i,M
| What is the Cost of Capital?
Estradas Model (2000)
Discount rates for NDI
What it matters is to estimate the
value of the project according to the
total risk assumed by the investor.
Then, the estimated value will not be a
market value, but a subjective
(consistent and unbiased) value.
The discount rate in this case becomes
a required return
The variable of interest is the degree
of investors diversification and the
degree of emerging markets
integration (country risk).
Estimation of the Cost of Capital
Definition of the Cost of Capital
Costs of the sources of funds
The cost of equity
The Weighted Average Cost of
capital (WACC).
Application: Eastman Chemical
Estimation of the cost of equity
Method
A discount rate could be a cost of
capital, a hurdle rate or a required
return.
In the case of a cost of capital, the
discount rate could represent only an
opportunity cost (conditions of
certainty) or it may also include the
risk premium added by the providers
of funds (conditions of risk).
There are two popular discount
rates:
I)the cost of equity capital
II)The cost of capital itself that
refers to the weighted-average
cost of the different sources of
funds. Why they are popular?
The cost of equity capital is usually
approximated using the CAPM, but
there are other alternatives such as
the Dividend Discount Model (DDM),
the Arbitrage Pricing Theory (APT) or
any other multifactor model.
 The cost of capital (WACC) is
calculated as the weighted average of
the costs of the different sources
of funds usually long-term debt,
preferred stock, common stock
and retained earnings.
The perspective that matters are those
of the investors, so if they hold a well-
diversified investment portfolio the
cost of equity will only reflect
systematic risk (beta)
Furthermore, whenever the firm
already holds debt, the systematic risk
will be levered otherwise it will be
unlevered.
The WACC includes systematic risk
(levered or unlevered)+ the
bondholders default risk premium.
Levered cash flows are also known as equity
cash flows, because it values just the equity
claim in the business. On the other hand,
unlevered cash flows are also known as firm
cash flows because it values the entire
enterprise.I am more accustomed to referring
them as equity or firm cash flows thus I will be
referring to them in that format for the
remainder of the article.
Equity cash flows are considered as cash flows
after debt payments and after making
reinvestments needed for future growth. The
discount rate used for these cash flows when
preparing a DCF model is the cost of equity
Free Cash Flow to Equity = Net Income -
CapEx + Depreciation - Change in Non-
Cash Working Capital +(New Debt Issues -
Debt Payments)
Firm cash flows are prior to any debt payments
but after the firm has reinvested earnings to
grow its assets. The discount rate used for
these cash flows reflects the cost of equity and
debt, also known as the weighted average cost
of capital (WACC).
Free Cash Flow to Firm = EBIT*(1-tax rate)
- CapEx +(Depreciation + Amortization) -
Change in Non-Cash Working Capital
In a DCF model the present value of equity
cash flows reflects only the value of equity
claims on the firm where as firm cash flows
reflect the value of all claims on the firm.
How to Convert from Firm to Equity Cash
Flows
This calculation is very simple. To get from firm
value to equity value simply subtract out the
market value of all debt and all other non-
equity claims in the firm.
Present Value of Debt - Market Value of Debt =
Present Value of Equity
Etrevista de banca de inverison
La banca d inverison tinee que ver con al gestiond
e colaboradores empresariales, adquisiones,
obtencin de capital, garantas coemrciales,
fonsods de inverison.
Reiben al mayor aprte de sysu ganancias por lso
bonos que aseguran, emisin y la venta de valores
en los mercados y prestacin de aseosamiento
profesional en colaboraicones ya dquisicones.
Banca de inversin Preguntas Entrevista
Ronda de persona
* Describir algunas de sus ventajas y desventajas?
Oportundiades de mejora: 3
Uno de mis retos es mejorar la disciplina de mis
salud fsica y para ello estoy llendo mas seguido
al gym para parasa car mas cuerpo y que me
entalle mejor la ropa. Ademas de eso poner mas
atencin en mis horarios de comida y en las cossa
que ingiero.
3 otr aspecto es que anteriormente
inverta demasiado tiempo en un solo
curso pero en este ao que se dio la
oportunidad de llevar cursos pesados
con otro cruso mdeianamente fuertes
y he aprendido ser ms eficiente y a
organizar mejor mi tiempo,
estabelciendo horarios desde la hora
en que leveantaba hasta que me
acostaba y es verdadermente
sorpredente todo el tiempo que se
puede aprovechar si estabelces un
buen horario.
Terco cuando hago un trbajo en unvierad tnego
algunas ideas y trato simrpe de buxcarles
susutento y ahcerlas de determinada manera, sin
embargo comrpafno con otro compaleros me
ehfado cuenta que hay otras formas de lllgar al
mismso resultados
Fortalezas: I)perseverancia III) trabajr en eqeuipo
IV)coimprometido
* Cul es tu mayor logro en la vida?
Un gran logro en en mi exepriencai priogesional
que fue mas bien compratidio con un eqeuipod e
trbajo fue la obtencin dela buena proc ed un
proeycto comercia penitenciario.
Era un proeycto que se encargba de la
infraestrucutra epoenitneciaria, disei y
conctruccion de un nuevo penal para la ciduad de
lima a cambio de recibir el terrno del penal san
Jorge para la cosntruccion e implementacin de un
proecytocomercial compuesto pro galaerias,
vivienda estabelcimeinto comerciales)
Tanto el costo de la conturcion del neuvo penal y el
proecyo comecial era de 72 MMde doalres en un
palzo de ejcucion de 3 aos el costo del penal era
de 37 mm aproximiademente, .
Los beneficios del estado eran obtener un nuevo
totalemnte eqeuipo y con mayor segurairad,
renovaicon urbana en elc ecrdao delima,
contrubion a la formalizaion del cemrcio, y la
apmliaicond e vacante de reclusos
* Cmo hacer frente a la crtica, en el trabajo y en
la vida personal?
* Cmo hacer frente con o superar las fallas?
* Cree usted, hay un lder en ti?
* Qu tanto cree en el trabajo en equipo?
* Cul ha sido el mayor fracaso de su vida, hasta
hoy?
* Dnde te ves 5 a 10 aos por delante en su
carrera?
en tres aos haber temrniado e l prgoram del CFA
y en 5-7 aos haciendo un MBA en una buena
undiversidad de USA, continuar trbajndo en banca
d einversion.
* Por qu eligi la banca de inversin como una
opcin de carrera?
Me gusto porque
Por qu deberamos contratarte?
Porque en primeri lugar tengo enormas ganas de
aprender sobre finanzas inverisons y mecado d
ecapitales, adems porque creo que re
Me gusta citibank porque adems de ser un
empresa muntinaiconal y super concida en el
mundo de la finanzas por su calidad en la
consultoria financiera e inversiones, cme parece
que tiene un buen ambiente de trbajo que permite
un buen desarrollo profesional y personal. Tnego
amigos que practicaron enel citbank y me
comentan de uss beuenas experiencias en el
banco tanto porque predenitron bastante y porque
el ambienta laboral era bueno.
Deje mi enteorio trbajo porque sent que quera
trbajr en una mepresa mas grande y en una
entidad financeira con ello tener mayores retos y
aspiraicones de lnea de carrera.
* Cul es la definicin de xito en sus trminos?
Hacerclo que mas tegusta y ser ujo de lso mejroes
* Excepto en la banca de inversin, cules son las
oportunidades de carrera que usted est
explorando en el mercado y por qu?
gestin de pratimonios porue es una rma que
tambin me gusta, armar portafolios, ver
rentbaildiades del protafolio y mejores
delsempeos del mismso.
Banca de inversin Preguntas Entrevista
Ronda de conocimiento industrial
Esto no es una ronda muy dura, siempre que ha
hecho su tarea en las ltimas tendencias
industriales, metodologas modernas, etc redondas
se abordarn las cuestiones que se ocupan de
toda la industria y algunas de las preguntas
tambin revisar su estudio sobre la organizacin,
donde se la intencin de trabajar! Por lo tanto,
asegrese de que la investigacin y el estudio de la
industria en profundidad, para que no se convertira
en blanco durante esta ronda. Aqu hay algunas
preguntas que debe conocer:
Cul es el ndice FTSE de la fecha de hoy?
* Cules son sus opiniones personales sobre los
titulares del Financial Times publicado hoy?
* Dnde se ven los tipos de inters desde 12
hasta 14 meses abajo de la lnea?
* Cuntenos sobre cualquier suceso del mercado
en el pasado reciente.
* Cul fue el precio de nuestra organizacin de
las acciones de ayer?
* Describir la situacin actual del mercado,
queremos conocer sus comentarios personales y
opiniones sobre el mismo?
* Quines son nuestros competidores ms
recientes?
* En qu reas es nuestra organizacin las reas La siguiente lista de preguntas de trabajo rene en
ms fuertes y que piensa usted, que es el ms
dbil y por qu?
Banca de inversin Preguntas Entrevista
Ronda Tcnica
Aqu viene la ronda tcnica hardcore! Su
conocimiento, experiencia y conocimientos
especializados que se someter a preguntas de la
entrevista dura y hay que responder a todas esas!
ronda tcnica implica, las cuestiones relativas al
trabajo y los trminos utilizados en el mundo de las
finanzas y la inversin. Por lo tanto, pasar por
todos sus libros sobre en mercado de inversin y
seleccionar las ms importantes y pidi a la
inversin comnmente preguntas de la entrevista
tcnicos bancarios.
De qu manera se calcula el WACC de una
organizacin?
* Cules son las tcnicas de blindaje ms
comunes?
* Especificar las partidas principales de un estado
de flujos de efectivo.
* Distinguir entre el estado de resultados y balance
general.
* Qu quiere decir con impuestos diferidos?
* Por qu crees, ambas organizaciones colaboran
entre s?
* Cmo se determina el valor de la empresa?
* Cules son los factores principales que afectan
el rendimiento de los bonos corporativos?
* Distinguir entre la puesta en comn de
contabilidad y de compra. Cul preferira usted
entre los dos?
* Cul es el significado de capital de trabajo y
cmo se determina?
* Cuntanos en breve sobre la descripcin del
trabajo de un analista de banca de inversin?
* Cul es tu mayor preocupacin en la banca de
inversin?
* Si usted conoce el resultado neto de
una empresa, entonces cmo determinar su flujo
de efectivo?
* De qu manera le valor de una organizacin?
* Cuntanos algo sobre la convexidad y la
duracin?
* Cmo se determina el delta de una opcin?
* Hblenos de la diferencia entre, riesgo de pago
anticipado y por defecto?
* Danos una breve descripcin del proceso de
suscripcin? Leer ms puestos de trabajo en la
banca.
una muestra lo que te puedes encontrar en una
entrevista en Banca de
Inversin. Jobandtalent recoge varios ejemplos,
alertando de la necesidad de repasar la actualidad
econmica a conciencia, especialmente las
operaciones corporativas que hayan podido darse
en la actualidad.
Muchos entrevistadores dividen las entevistas en
tres secciones: preguntas genricas, preguntas
tcnicas y brains teaser
Preguntas genricas en la entrevista en Banca
de Inversin
Cuntame que pone en tu CV
Qu hacemos en Banca de Inversin?
Qu sector te interesa ms y por qu?
Podras decirnos alguna persona
prestigiosa que trabaje en el sector?
Por qu quieres trabajar en este rea
concreta de Banca de Inversin?
Qu haces cuando no ests estudiando?
Qu estarn haciendo en 5 aos? Y en
10?
 Hblame de una situacin de trabajo en Cuntas pelotas de golf necesitas para
equipo en la que tenido que solucionar un llenar el Metro de Madrid?
conflicto.

Cul ha sido el mayor reto al que te has Oferta de analista de banca de inversi
enfrentado en tu vida?
Cmo establecera el valor de una compaa de
Tienes alguna pregunta para m?
biotecnologa?
Preguntas tcnicas en una entrevista en banca
de inversin
Oferta de analista de banca de inversin
Qu es un DCF? Explcame como haras
uno.
Imagine un pas sin red mvil que quiera vender
Cules son los diferente mtodos de algunas licencias a operadores de redes. Qu
valoracin?
hara usted para valorar el mercado?
Cul es la diferencia entre un LIFO y un
FIFO? Oferta de analista de gestin de patrimonios
Cundo emitiras deuda y cundo
acciones? Si quiero comprar una casa y tengo el dinero

Qu es el EBIDTA? en diferentes divisas, cul es la moneda ms

beneficiosa que puedo utilizar?
Cmo vara el capital circulante si tus
proveedores te dan ms plazo para pagarles?
Oferta de analista de banca de inversin
1532?

Cmo calculas el FCF? Si tuviera una suma considerable de dinero para

Explcame lo que es la crisis en 5 minutos
y en ingls
Cmo calculas la depreciacin?
invertir en una empresa (con una gran
participacin), qu le gustara saber antes de
invertir en ella?

Brain Teasers comunes en banca de inversin Oferta de analista de banca de inversin

Si doblas una hoja sobre si misma 20

veces, cul sera el grosor resultante? Soy el CEO de SAS [la areolnea sueca] y me
gustara mejorar mi imagen y aumentar el nmero
Qu ngulo forman las agujas de un reloj
a las tres y cuarto? de pasajeros y la satisfaccin de estos. Qu me

Tienes 10 canicas: 9 tienen el mismo peso y recomienda hacer?

una pesa ms que las otras. Cuntas
pesadas tienes que realizar con una
balanza para identificar la bola que ms
pesa?

Cul es el valor de un cupn cero a

perpetuidad?
DIFERENCIAS ENTRE PRIVATE EQUITY Y En general, la estructura de la presentacin ser
VENTURE CAPITAL del tipo:

Private equity y venturare capital son dos ripos de Resumen de la inversin : invertimos en
fondo de capital que se basan en comprar esta compaa?, sustento y riesgos de la
empresas(o parte de ellas) y venedralas mas inverison o compra de laccion punto de vista
caracs. cualitativo/anlisis de la industria.
Valoracin: en estas 2 diapositivas
cunto vale esto y a cuanto creo que podra
valer en el futuro?. Nadie te va a preguntar por
Ventura capital Private equity
qu usaste una beta de 1, o un crecimiento del
2%.
Empiezas con la gente y luego tratas de Empicezas con los nmeros y luego
averiguar que nmeros puedes hacer con tratas de encajar
todo
Si en los nmeros
tienes acceso a compaas
ellos comparables pblicas y transacciones
Es una inversin de menor
privadas, riesgolos
incluye porque
mltiplos.
Es una inverison de mayor riesgo porque se compran empreas o proyectos en
se comrpar en empresas en sus etapas e etapas mas amduras de operacin.
iniciales de operaciones Por ltimo, incluir la cuenta de prdidas y
ganancias, el flujo de caja, y los retornos con
Es el capital financiero en las primeras sensibilidades
Adquiere una empresa respectocon
ya existente a los parmetros
ms sensibles (
etapas de una mepresa con alto potencial productos y FC ya existentes, para
pero de alto riesgo. reestreuc turarla y optimizar sus
rendimeinto financiero
tieneymucho
una vez
ms que
inters analizar que
El fondo de capital riesgo aporta dienro haya emjroado pasara
venderlaside
el nuevo.
plazo medio de cobro cambia de
necesario par ecrer a cmabio de entrar en 150 das a 90 das debido a la legislacin).
el capital de la sociedad.
Cuando funciona Aspectos
bien cualitativos
peudes salvara de la industria :
bsicamente
empreas de la bancarrota crecimiento
y convertirla endel volumen de sta,
La 1era inversin tpica de VC s produce competidores,
empreas rentables de nuevo. cambios de legislacin, cambios
despus de la ronda de financiacin en la tecnologa, etc
semilla y es una ronda para financiar el El rango de ivnerisones es muy grande
crecimiento, se conoce como Serie A y Carry:retorno
aunque no peudes er menorfuturos del fondo.
de 50-100
5 preguntas para ganarte al recruiter en una
suele rondar los 2MM. millones de eruros o dlares en USA y
entrevista de banca
EU. Conlleva el uso de deuda en
Todas estas rondas terminan cuando se operaciones llamadas LBOs
1)pregutna la iuntimo de la entrevista, ks tienes
produce una salida, ya sea una venta
alguna pregunta?
estratgica(es decir una empresa mas
grande la compra) o una salida a la bolsa
Como se siente en banca d einveriso ne le
citibank?
Ambos tipos de gestoras tambin es importante la tarea de captacin de fondos. Es
decir el trbajo de lso socios de stas gestoras es bucas dinero
1. par apoder
Qu utilziarlo para
porcentaje del trabajo de un
invertri analista/asociado (segn la posicin para la
que te ests entrevistando) es pitching y que
nivel de exposicin a la realizacin de modelos
puedo esperar?
La diferencia entre la banca de
inversin/consultora y el capital riesgo radica 2. Le hace poco acerca de una operacin que
en que una vez hecha la inversin, los segundos desarrollo su grupo con la empresa X. Durante
son dueos de la compaa mientras que los esta operacin, quin facilito la financiacin
primeros ya estn trabajando en otro del deal y cun a menudo utiliza su grupo a
proyecto. otros bancos como medio de financiacin?

En cuanto a preguntas tcnicas, en general

pueden aparecer los siguientes tipos:
4. Qu le influy a usted a la hora de decidir
desarrollar su vida profesional en este banco y
no en otro?
5. En este trabajo el horario puede ser muy
exigente y a veces puede ser difcil compaginar
vida personal y vida profesional Cmo lo hace
usted para compaginar la vida profesional y la
vida privada y familiar?
Responder a cuestiones como "cules son tus
aptitudes personales?" o "qu puedes aportar a
esta empresa?" es un juego de nios si se
compara con preguntas como "por qu no tienes
mejores notas?"
A un aspirante a ingeniero de software en la tienda
on line le pidieron que resolviese el siguiente
problema de lgica: "si tenemos dos recipientes,
uno con capacidad para tres litros y el otro para
cinco litros, cmo llenaras uno con cuatro
litros?".
Que es banca de inverison? En que consiste
exactamente trbajr en M&A?
Es asesoramiento financiero prestado a empresas
o fondos de Private eqeuity funciones:
1.Operaciones de compra/buy side):una
mepresa o un fondoe privete eqeuity ocntrata a un
banco de inverison para que le asesore de cara
a la adquisison de una compaa. El papale del
banco ser vlaorar la empreas objeivo para dat
una recomendaicon del rpecio que tendr que
apgar por ella
2. Operaciones de venta (sell-side): Una
empresa o un fondo de Private Equity contrata a un
Banco de Inversin para que busque potenciales
compradores de su empresa. El Banco se
encargar de comenzar un proceso de venta en
el que contactar a compradores potenciales y
ser el nexo entre comprador y vendedor
3.Bsqueda de financiacin: Una empresa
contrata a un Banco de Inversin para llevar a
cabo una operacin de financiacin. El Banco
se encargar de recomendar a su cliente la
alternativa de financiacin que ms le
convenga y ejecutar el proceso. Dentro de las
alternativas destacan: salida a Bolsa,
ampliaciones de capital y emisin de
bonos(bonds issuing)
Cuales son las salidsa profesionales
habituales? Donde peudo estar en 4 o 5 aos?
La saldida leugo de trbajr 3-5 aos en un banco de
inverison es un fonod de privete eqeuity, asesor.
Cmabiar de banco de inverison o boutique de M&A
para aplciar el conmciento en un entorno distinto.
Dentro del amplio sector de Banca de Inversin,
existen 3 posibilidades:
Banco de Inversin: son grandes instituciones
financieras que cuentan con Banca Comercial y
Banca de Inversin. La principal diferencia
respecto al resto es que tienen la capacidad de
prestar financiacin a sus clientes. Suelen tener
los mandatos ms grandes de empresas cotizadas.
La matriz suele estar en Londres o Nueva York y
tienen oficinas regionales por el resto del mundo:
Se puede dividir en:
Bancos americanos: Goldman Sachs, JP Morgan,
Morgan Stanley, Merril Lynch, Citigroup
Resto de Bancos: UBS, Deutsche Bank, Barclays,
Nomura, Socit Gnrale, etc.
Boutiques de M&A: son asesores con un foco
local que no pueden prestar financiacin a sus
clientes. Suelen tener un tamao ms pequeo
y encargarse de operaciones a nivel nacional.
Se podra dividir en:
Internacionales: Rothschild, Lazard, Mediobanca,
etc.
Nacionales: Montalbn Atlas Capital, GBS
Finanzas, Arcano, AZ Capital, 360 Corporate, etc.
Big Four: las multinacionales denominadas Big
Four (PwC, Deloitte, E&Y y KPMG) tambin tienen
sus departamentos de M&A. Suelen tener
mandatos ms pequeos que, en ocasiones,
vienen derivados de un mandato de Due
Diligence Comercial o Financiero.
Como conseguie un puesto de analsita de
banca de inveirson
Existen varias formas de conseguir un puesto de
analista en Banca de Inversin:
Summer Internship: es la forma ms habitual de
conseguir un puesto en un Banco de Inversin
internacional. En el penltimo ao de carrera, el
candidato realiza unas prcticas de verano de 6-8
semanas y, al finalizarlas, le comunican si le hacen
oferta para comenzar a trabajar cuando termine la
carrera. Es el mtodo ms utilizado en los Bancos
de Inversin en Londres
Full-Time Analyst: tambin existe la posibilidad de
entrar directamente como analista, sin tener que
hacer prcticas. Este formato es ms habitual en
las oficinas regionales de los Bancos de Inversin y
en las boutiques de M&A
Off-Cycle Analyst: es una modalidad muy habitual
en las oficinas regionales de los Bancos de
Inversin y en las boutiques de M&A. El sistema es
el mismo que el de Summer Internship pero con la
diferencia que tiene lugar en cualquier momento
del ao, en funcin de las necesidades de cada
momento. Segn la oferta, puede implicar trabajar
unos meses de prcticas e incorporarse como
analista a continuacin
Lo que realmente buscan es personas con gran
disposicin para trabajar en el sector, las ideas
muy claras y un Curriculum que demuestre ganas
de aprender e inquietud.
Los principales elementos en los que se va a fijar
un recruiter son:
Prcticas: haber realizado anteriormente prcticas
en el sector de Banca de Inversin sin duda ayuda
mucho, si bien no es requisito imprescindible. Si no
has realizado prcticas nunca o han sido en otro
sector, tendrs que estar preparado porque te lo
van a preguntar en la entrevista.
Expediente acadmico: al contrario que ocurre en
otros sectores, es importante pero no es
imprescindible que sea brillante. El expediente
actuar como un check para el recruiter que
confirme que el candidato ha obtenido resultados
aceptables. Nuevamente, en caso de que tu
expediente no sea bueno, tendrs que tener
preparada la respuesta porque te preguntarn
sobre ello
Idiomas: Es un requisito fundamental tener un
dominio absoluto del ingls, puesto que todo el
trabajo en el sector se realiza en este idioma. An
para un puesto en una oficina regional espaola,
lo habitual es que parte de la entrevista la
hagan en ingls (a veces toda la entrevista es
en ingls)
Bsqueda de informacin: en primer lugar, debes
tener muy claro las 3 posibilidades que ofrece el
sector (Bancos de Inversin, Boutiques de M&A
y Big Four).
1 ronda: entrevista con analista/asociado - Es la
entrevista ms tcnica y en la que tendrs que
demostrar que has estudiado mucho para
prepararla. Te harn preguntas relacionadas con el
sector de Banca de Inversin, pero tambin es
posible que te hagan brainteasers y preguntas de
agilidad mental y matemtica (ver
2 ronda: entrevista con Vice-Presidente - Su labor
es hacer hincapi en aqullos puntos dbiles que
el analista/asociado hayan detectado, tanto
tcnicos como motivacionales. Por ello, es muy
importante que tras la 1 ronda, revises todas las
preguntas que te hicieron y ests seguro que lo
entiendes bien. Aqullas que no supiste contestar,
debes estudiarlas mejor porque lo ms seguro es
que te las vuelvan a preguntar. Es una entrevista
que mezclar aspectos tcnicos con
motivacionales
3 ronda: entrevista con Executive Director - A esta
ronda slo llegarn los mejores, aqullos que
tienen posibilidad real de recibir una oferta. El
Director asume que has pasado el examen tcnico
y buscar tu motivacin, tu conocimiento del sector
de Banca de Inversin, tu conocimiento sobre la
firma y lo que puedes aportar dentro de ella. Esta
entrevista no se puede preparar, simplemente
tendrs que demostrar que eres la persona
adecuada.
4 ronda: entrevista con Managing Director: a esta
entrevista slo llegarn 2 3 candidatos. El
Managing Director har preguntas muy generales
para ver cmo piensas y las ganas que tienes de
entrar en la firma. Si consigues manejar los
nervios, seguramente sea la entrevista ms fcil y
la que menos hay que preparar. Lo importante es
tener un conocimiento muy alto de la firma, sus
ltimas operaciones y cul sera tu rol dentro de la
firma. Es una entrevista en la que el feeling de
cada uno se hace imprescindible. Recuerda que es
una entrevista a dos bandas (t tambin les ests
entrevistando a ellos!).
Prcticas (3-6 meses): El primer paso es llegar a
conseguir una oferta de analista tras unos meses
de prcticas. Durante el periodo de prcticas, el
candidato ha tenido que demostrar su capacidad
para aprender rpidamente, manejar la presin y
tensin habitual del trabajo y cometer los menos
fallos posibles. Seguramente sea el periodo ms
duro pues el candidato tiene que trabajar duro para
aprender muy rpido y acabar las prcticas
trabajando como un analista
Analista (3-4 aos): durante estos aos la curva
de aprendizaje es incomparable a ningn otro
sector. El analista (con la ayuda del asociado) ser
el encargado de gestionar todo lo referente a un
mandato o pitch: modelo financiero, presentacin,
reuniones, coordinacin entre asesores,
coordinacin entre compradores, etc. Aunque suele
requerir mucho trabajo, la recompensa moral suele
ser muy alta.
Asociado (3-4 aos): supervisa el trabajo del
analista y tiene la responsabilidad en la elaboracin
del modelo financiero. El asociado es el encargado
de que todos los nmeros sean correctos y ser la
persona a la que todo el mundo preguntar sus
dudas. Asimismo, el asociado tiene que estar
seguro que el analista hace bien su trabajo y
tendr que estar encima de l para evitar fallos.
Vice-presidente (3-4 aos): encargado de
manejar los equipos en cada operacin. Los
Directores dan instrucciones al Vice-presidente y
ste se encarga de la organizacin del trabajo con
los analistas/asociados. Asimismo, ser el
encargado (junto con el asociado) de mantener la
relacin de trabajo con el cliente.
Executive Director: Ser la mano derecha del
Managing Director, encargado de originar nuevas
operaciones as como mantener el da a da con
los altos ejecutivos de las empresas. Acompaar
al Managing Director en sus reuniones y ser el
encargado de estar al da de las operaciones.
Managing Director: Es la mxima categora
dentro de la Banca de Inversin. Su misin es
conseguir nuevos clientes y mandatos. Una vez lo
consiga, ser el Executive Director el que se
encargue de hacer el seguimiento y trabajo. Suelen
ser personas con una amplia red de contactos,
grandes habilidades comerciales y mucha
experiencia en el sector.
En Europa, la mayora de Bancos de Inversin
tienen su sede central en Londres. All se
encuentra el grueso del equipo y los altos
ejecutivos de la firma. En Londres, los equipos
estn distribuidos por departamentos
especializados. As, estar el equipo de
Telecomunicaciones, Recursos Naturales,
Consumo, Transporte, etc.
Estos equipos tienen una doble funcin:
(i) trabajar en las operaciones que les hayan
encargado sus Managing Directors de Londres y;
(ii) servir de apoyo a las oficinas regionales de
Europa.
En las oficinas regionales no existen
departamentos, de manera que todo el equipo se
dedica a M&A general y pedir apoyo al equipo
especializado de Londres cuando lo necesite para
un sector en especial.
Un dia en la vida de un analista en banca de
inverison
No hay dos das iguales en Banca de Inversin
Al contrario que otros sectores, un analista de
Banca de Inversin va a estar a la vez trabajando
en varios proyectos. Esto requiere habilidades por
encima de la media para manejar varias tareas.
Normalmente, el analista va a estar trabajando al
mismo tiempo es una ejecucin, otra ejecucin
empezando/acabando y un pitch.
Maana: La ejecucin va a ser siempre la
prioridad, por lo que tendrs que leer
detenidamente los emails que hayan enviado por la
noche y resolver los temas que surjan. Pueden
surgir temas relacionados con: un cliente pudiendo
un anlisis especfico, los asesores de las partes
pidiendo mayor informacin, analizar alguna noticia
filtrada sobre tu operacin, etc. A primera hora de
la maana te sentars con el equipo para analizar
los primeros pasos y distribuir las tareas.
Una vez hayas acabado con los temas urgentes,
todo Analista de Banca de Inversin debe dedicar
un tiempo a leer la prensa diaria, puesto que todas
las operaciones en las que se trabaja suelen tener
impacto en las noticias econmica diarias.
Asimismo, momento para relajarse un poco, hablar
con el resto de compaeros y respirar un poco.
Vueltos al trabajo, el analista se enfocar en su
ejecucin incipiente. Esto implica iniciar contactos
con inversores potenciales, empezar a redactor un
Information Memorandum, reuniones iniciales con
el cliente, gran entendimiento del sector y empezar
a hacer el modelo financiero.
Comida: normalmente la hora de la comida
depende de tu disponibilidad en ese momento. Una
vez ests seguro que no tienes nada urgente, es el
momento para relajarse, rerse y hablar de
cualquier cosa no relacionada con el trabajo.
Tarde: si las ejecuciones no requieren mayor
tiempo, estars ocupado con el pitch. Los pitches
te ayudan a adquirir gran conocimiento sobre un
sector nuevo, modelar anlisis financieros distintos
y hacer brainstorming sobre potenciales inversores
u oportunidades para la Compaa. Una vez
terminis el pitch, normalmente acudirs a la
reunin con el cliente y escuchars de primera
mano su visin. En el mejor escenario, el pitch
termina con una ejecucin.
Noche: el sector de Banca de Inversin es All the recomendations all exclusive receives a c
conocido por largas horas de trabajo y noches en work for a pension or mutual fund Sell side ann
vela. Sin embargo, no todos los das requieren que provide fund specific recommendations brokerage n
te quedes hasta tarde en la oficina, solamente not to outsiders. recommenda
cuando alguno de los proyectos descritos recommedna
anteriormente te ha consumido mucho tiempo. La to all clients
perfeccin del trabajo, las entregas urgentes, la
modelizacin de distintos escenarios, normalmente
The Buy-Side Job Description
conlleva mucho tiempo de trabajo y dedicacin.
is much more about being right, ebenfiting the fund
En general, ser analista en Banca de Inversin es with high-alpha iadeas is crucial, aboiding major
extremadamente motivante y tiene una curva de msitakes. Avoiding the negative is often a key part
aprendizaje que no tendrs en ningn otro sector. of the buy-side analysts job, and many anaysts
Tendrs exposicin a las Compaas y Private purseue their job from gifuring out what can go
Equities ms grandes del mundo, analizars wrong.
impactos financieros de operaciones de M&A y
adquirirs gran experiencia en el mundo financiero. Read news, tracking down information, building
models,
Sell side job description Buy side job description
-Is to follow comanies, all typically in the
Whereas many sell-side analysts try to spend
same industry, and provide regurlar much of their time finding the best sources of
research reports to the firms clients. information about their sector, many buy-side
-As apart of the process, the anayst wil analysts spend that time trying to sort out the
typically build models to project the most useful sell-side analysts. That is not to say
frims financial results, as well as speak that many buy-side analysts do not do their own
to the comstumers, suppliers, proprietary research (the good ones always do),
competittors and other soruces. rather it just means that there is significant value
- the ultimate outocem of the analyst to a buy-side analyst in developing a list of the
works is a research report that is a set of real go-to analysts in their space.
fincnial estimates, a price target and a
recommmedntaion as the stocks Buy-side analysts are also often indirectly
expected performance. responsible for a sell-side analyst's
-in practice the job of the analuyst is to compensation. Buy-side analysts often have some
convince insititucional acoocunts to say in how trades are directed by their firm, and
that is quite often a key component of sell-side
direct their trading thorug the trading
analyst compensation.
desk of the anayst firm and the job is
aobut marketing. Tryin to be the firt to
Key Differences
the client with new and different
Although both sell-side and buy-side analysts are
information. charged with following and assessing stocks, there
-insitittuional investor will reward people are many differences between the two jobs.
who meet with them
-it os laike a high price travel agent. On the compensation front, sell-side analysts often
-analyst will also create expert networks make more, but there is a wide range and buy-side
that ehy can rely upon for a constant analysts at successful funds (particularly hedge
stream of information funds) can do much better. Working conditions
arguably tilt in the favor of buy-side analysts; sell-
side analysts are frequently on the road and
Employer Employer often work longer hours, though buy-side
Fund manager Clients analysis is arguably a more pressurized job.
Buy side analyst work for a emsion or They work for a brokerage or a fimr
mutual fund, they research provide that manages Speaking realistically,
individual sell-side analysts are paid
and diferetn
recommemdnations to the money accounts. largely for information flow and access the
manager that employ them. Detmerine management (and/or
They offer recommendatiosn firms high-quality information
investment potenctional and whteher it sources). Compensation
clients what to buy or sell,evry time for buy-side analysts is
fits the funds strategy. much
the client trade themore
stockdependent
the brokerupon the quality of
recommendations the analyst makes and the
overall success of the fund(s).
The two jobs also differ in the role accuracy plays.
Contrary to what many investors expect, good
models and financial estimates have less
weight to the role of a sell-side analyst, but can
be critical for the buy-side analyst. Likewise,
price targets and buy/sell/hold calls are not
nearly as important to sell-side analysts as
some financial media might seems to think. In
fact, sell-side analysts can be below average when
it comes to modeling or stock picks but still do
alright so long as they provide useful information.
On the other hand, a buy-side analyst usually
can not afford to be wrong often - or at least not
to a degree that significantly impacts the fund's
relative performance.
Buy-side and sell-side analysts also have to abide
by different rules and standards. Sell-side analysts
have to pass several regulatory exams that buy-
side analysts do not even have to take. Likewise,
buy-side analysts typically enjoy less restrictive
rules on share ownership, disclosures and outside
employment, at least insofar as regulators are
concerned (individual employers have different
rules concerning these practices).
The Bottom Line
Likewise, dedicated sell-side analysts can typically
dive deeper than buy-side analysts and really learn
the ins and outs of an industry. For readers
considering a career on Wall Street, though, it is
important to understand the differences and pursue
the career path that really best fits their skills and
demeanor.
Bootom- up
Ambos of these approaches have the ssame goal to know stocks
statetegies to selecto companies in which to invest
-pasa por alto el la condiciones econmicos y sector -Involves analyzing the big picture.
sino mas bien on selecting a stock base don the
indidivual attirubutes of a Company.
-This kind of investors simply seek strong
companies with good porospects regarldless(sin
iportar) of industry or macroenomic factors.
Conversely(inversamente)
-That constitutes good prospects however is a
mater of a opinion based:
-looking earnings growth
-find companies with low Per ratios attractive.
-Based in these fundamentasl
-as long as the companies are strong, the business building industry would benefit theBank
cycle or industry conditions are of no concern.
chang
search
Comp
-
Cementos apcamsayo
First of all I want to thank you for your presence
and time here.
Because I want to tell you about a very important
company in the infrastructure and construction
sector in Peru more scpecifaclly in the cement
maket
Cementos pacasmayo is a leading
As this teackir rtha t refers to common stocks
And the evolution of the ebitda and eboitda margin
% as seen in the presentation
has a clear positive tendency from 2012 to this year
and the stimation for 2017 is a major increase.
This implies that the core business remains solid
and stable with growth opponruietes. Th
In the case of revenue bars graph these have been
more volatile due to new invesmet proejects, and
as conscuences dpreciacton and financial costs like
interes
And then here is the shareholders estructure to
third quarter: 50% of shares it belongs to
invesiones ASPis, 14% to Peruvian pension funds ,
18% to ADR program
The eqeuity it is compounded by two kinfd of
stocks: common and investments stocks
Top Down
General
meeting of shareholders.
opportunities are More thant 531
MM of stocks and 50 mm of invement stocks.
A Cementos Pacasmayo ADR represents five
Look at the economy and try to
common shares. ADRs can be exchanged for
forecast which industry will
common shares listed on the Lima Stock Exchange
genearate the best retruns.
(BVL) and common shares may be exchanged for
-Else investors then look for
ADRs listed on the New York Stock Exchange
indivual companies whithin the
(NYSE). The ADR liste in NYSE as CPAC.
chosen industry and and add stock
to their
Inportfolios.
the case of ADRs. Dividends are paid in US
Ej: suposr you
dollars andbeliev
are subject to withholding tax in Peru
be a drop
with ainrate
tinterest rates
of 6.8%.
Using top down approach, you
might The custodian
determine thatbank of Cementos pacasmayo's
the home-
ADRs is JP Morgan Chase
most from
2) nowthethe
macroeocnomic
oultlook and analystis of the industry
This table shows us how the Peruvian cement
market is divided in three regions: southern, central
and northern. As you can see the firm has been the
indisputable leader in the northern region and also
it always has obteined around 20% share of the
total market.
In the industry th egrph illustrates that cemtnos
pacsamayo hast the best ebitda margin compared
to its competence. As you can note ebitda margin is
almost the double of each competitors such as
cemex argos
This outcome can be explained because of its cost
eficent operations and also due to its focuse in the
growth of its core busness cement and cemente
related products.
3) continuing with the industry it is important to
mention that the oppotunitiy growth comes from
infreatructure gap for the next 10 years for 160
thousand oof millones of dollars. Especially in the
trasnportacion , tleecomunitcaions and energy
sectors. As it can be reflect in the raking
infreastuecut competitiecness. Peru hasa the
greater infraestrucutre deficit.
And in parallel recalling that cementos pacasmayo
contains about 20% of the cement industry
But also we should mentioned about possible risks
and mitigations
On the strength sidesit can be recalled that the
frimahas t20% market share
High levels of liquidity to afford financial costs
Baarries to entry into industry
Some weaknese is insufficient prodcutos
diversifcations, are to much focus in cement but
they are trying develop more elaboretd products.
On the opporunties side: greater prodctions and
sales to attend nortehren demdnas.
Recovery of public and private invemente
infreastructure
Threatsmdoerate levels of levaerage so future
growth depedne on capital contribution
High corrleaiton with public an privete investment
Some riks that can affect the value of the company
are:
Exchange rate risk due to debt in us dollars and the
a possible solutiocn coulb be acquire financiallt
isecurities such as cross currency swaps this are
contratcs to hedge cash flow in other currencies in
this case to hedge corproativ bonds in us dolars.
.in 2015 oss currency sswaps to razonable value
reflects changes in 2015 ha a value of 124 mm
soles and so far this year its value is aorund 82 mm
soles. This securities works as
So far this year the firm holds cross currency
contracts for a nominal vlue of 300mm de doalres
mesure in razonble value. Los saldo of this
cosntracts changes with the level of future
excahange rates.
In fact the cash flow hedge of the future payments
was considered as very effective, for this concept
the firm was able to anticipate a loss of more than
42 mm soles
Th razonable value of cross currency swaps are
measured based in market data considering a
swaps valuation models using resent value. This
models take into account different factors,
includingcredit rating of the counterparts,
currencies, foraward rates, interes rates cruves.
So far this year there has been a moderate
exchange rate volatility. This effects wre partially
mitigated by the exchange rate hedge for the
corporate bonds
But the group does na thave other financial
intruemnts to hedge the echange rate, interest rate
ormarket prices volatility sucha s carbon prices in
the market
so for the first risk it is good to consdiere a cross
currency swaps.
It allows you to exchange payment flows in one
currency determined by another flow in a different
currency.
why?
Need to hedge exchange rate risk arising from a
flow of payments in a
Unwanted currency (eg income in soles and debt in
dollars or vice versa)
Take advantage of better levels of financing than
in the conventional market (eg take a debt in soles
plus a CCS from PEN to USD as an alternative to
obtain
A better rate in dollars than taking a traditional loan)
Advantage:
It allows to set in advance the future exchange of
two payment flows in different
Eliminating the uncertainty of future exchange rates
Forwards)
Possibility of taking advantage of better financing
conditions in a given currency, taking it in a different
currency and using the cross currency swap to
exchange the flows of this debt for others in the
desired currency, obtaining better rates of financing
than the traditional alternatives
No initial cost
And benefits for a participant in such an operation
may include obtaining financing at the lower
interest rate than available in the local market,
Disadvantages:
Contractual obligation of future exchange,
eliminating the possibility of taking advantage of
More favorable market exchange rate levels
Notes:
For liquidation you can choose between the
following modalities:
Or Delivery: At each exchange date, the physical
delivery of the amounts of each flow of payments is
made.
O Non Delivery: At maturity, the delivery is made by
compensation considering the difference between
the amount paid and the amount received by the
customer
The client has a debt in soles with a rate of 7.00%
PEN that he wants to transfer to dollars.
With CCS, the client receives on each payment
date the amount in soles needed to honor his debt
(PEN 7.00%) in exchange for paying a dollar
amount that depends on the USD agreed rate
(USD 6.50%).
In net, the client has converted its debt into soles
to a debt in dollars.
The customer has a dollar debt with a 10.00%
PEN rate that he wants to spend on soles.
With the CCS, the client receives on each
payment date the amount in dollars necessary to
honor his debt (USD 7.50%) in exchange for paying
an amount in soles that depends on the agreed
PEN rate (PEN 10.00%).
In net, the client has converted its debt into dollars
into a debt in soles.
It should be spscific, it is important to note
The results of the company were in line with the
market estimates, becasue: i) no major changes in
revenues are expected, because of the additional
sales made in 3Q2015 for prevention work against
the Child Phenomenon, ii) An improvement in the
EBITDA margin is anticipated, due to the greater
efficiencies that the new Piura plant will generate.
Net income fell 20.9% in the 3Q 2016. Despite the
improvement in the EBITDA margin (33.2% vs.
31.8% in 3Q2015), there was also a greater impact
on the company due to the additional depreciation
of the Piura plant, and the interres expenses. In
result, it recommends to buy Cementos Pacasmayo
stocks because it remains under its fundamental
value around S / .7.10 (today S / .6.18) and it is
expected to raise.
The bank sells dollars at a spot exchange rate
Customer receives the dollars
Client pays in loan at doalres at a lower rate
Bank buys at forward exchange rate
Soles credit is canceled
Allows to fix in advance the future exchange of
payments in different currencies, eliminating the
uncertainty of future exchange rates. There is the
possibility of taking advantage of better financing
conditions in a given currency, taking it in a
currency and using the cross currency swap to
exchange flows
On the date of exchange the physical delivery of
the amounts of each flow of payments is made, the
spot exchange rate against the forward exchange
rate implicit in the contract is compared, and the
differential against is paid by the corresponding
party.
The forward exchange rate is defined as the
exchange rate applied to the amounts of each flow
of payments.
For the second risk should be cosndiered a and
iflation derevates like swaps iflation.
It is used to mitigate the effect of potencially large
levels of inflation. In which which a counterparty's
cash flows are linked to a price index(in this case
IPC) and the other counterparty is linked to a
conventional fixed or floating cash flow
Many investors prefer inflation protection from
derivatives because unlike inflation-indexed
bonds, a significant amount of capital isn't
required and it's more flexible. Inflation
derivatives require the buyer to provide a small
premium to the swap provider. In most cases the
Consumer Price Index (CPI) is used measure the
differences in annual inflation.
An inflation swap is a derivative used to
transfer inflation risk from one party to another
through an exchange of cash flows. In an inflation
swap, one party pays a fixed rate on a notional
principal amount, while the other party pays a
floating rate linked to an inflation index, such as
the Consumer Price Index (CPI). The party
paying the floating rate pays the inflation adjusted
rate multiplied by he notional principal amount.
For example, one party may pay a fixed rate of
3% on a two year inflation swap, and in return
receive the actual inflation.
BREAKING DOWN 'Inflation
Swap'
Investors use inflation swaps to hedge inflation
risk. A more complicated example of an
inflation swap would be an investor purchasing
commercial paper. At the same time, the investor
enters into an inflation swap contract, in which he
receives a fixed rate and pays a floating rate
linked to inflation. By entering into an inflation
swap, the investor effectively turns the inflation
component of the commercial paper from floating
to fixed. The commercial paper gives the investor
real LIBOR plus credit spread plus a floating
inflation rate, which the investor exchanges for a
fixed rate with a counterparty.
For the third problem it can be used a energy
derivate contract based in an underlying enrgy
asset in this case the carbon price it would be
feasible or possible a forward or swap contract.
Energy derivatives include exchange-traded contracts
such as futures and options, and over-the-counter
(i.e., privately negotiated) derivatives such as
forwards, swaps and options. This describes the
process used by corporations to reduce their risk
exposures to the movement of carbon prices in this
case whichs import from Colombia.t the approieta
contract for the firm would be forward
A forward contract is a customized contract
between two parties to buy or sell an asset at a
specified price on a future date. A forward
contract can be used for hedging or speculation,
so its non-standardized nature makes it
particularly apt for hedging.a forward contract
can be customized to any commodity, amount
and delivery date. A forward contract settlement
can occur on a cash or delivery basis. Forward
contracts do not trade on a centralized exchange
and are therefore regarded as over-the-counter
(OTC) instruments. While their OTC nature
makes it easier to customize terms, the lack of a
centralized clearinghouse also gives rise to a
higher degree of default risk.
a forward contract is a agreement to buy and sell
ans asst in a future day,the price for the asset is
fixed at the time the contract is assecuretd. This
contract dont trade on an exchange, also are
settle at the end of the contract term. Parties who
want to hedge th volatility inherent in the
underlying asset use forward contracts. Also are
highly costumazilble manay corporations use
them to hedge commodities. In this case the firm
uses carbosn as a mateira prima so the firm can
enter to a forward contract with a large proveedr
for example to a Colombian firm whom always
been bought the carbon, so the firm buy an
specific qeuinty and price o carbon to be
delivered in a specific date with a cash
settlement, if at the end of the contract the marke
price of carbon in colombia is higher than the
price that was settle then the company gain
profits

Prices change daily in the marketplace and are

marked to market on a daily basis..
At expiration, the buyer takes delivery of the
underlying from the seller or the parties can
agree to make a cash settlement.
The comnay is a subsidiary of inverisiones ASpi
thath pooses 50.01% of common stocks to the third
qurter.
th
In 16 may of this year th ecomany deicide the
dissolution of theris subsidiaria caliza del norte .
Also in 26 september is twas aprovo a escicion of
part of eqeuity pertenenciente al proeyctos fosfatos
in favor of a comnay Fossal
In order to finance proeycto salmueras the general
meetong of shsare holders of two subsisdiarias
deicide to make a contribution for more than 4
million of soles and 473 mill.
This contributions are parto of the invement
commitnment assumed for this subisdiari if the
proeyctos salmueras se lelvava a cabo hasta pro
100 MM y 14MM de diolares.
During this year there were adtions in properties,
plant equipment for more than 90 mm soles less
than thn 2015 en que als cifras were more tahtn
500 mm of soles ddruing the same period to
September 2015, durin this year or so far this year.
The financial costs because of the cosntrucction of
a new plant in pirua durin this year was 3MM
soles, considering that in 2015 the expenses were
29mmn soles.
The costos of the debt was 5% as the effective
annual costs
Eranigns per shar=net income/with average of
between commn stocks and invement stocs
outstanding.
Notticians de transasacciones
Infraestructura lider el
mercado de fusiones el
2016
Operaciones en este sector habran
movido ms de US$800 millones en el
mercado de fusiones y adquisiciones
peruano.
por ejemplo, tenemos el caso del gigante brasileo
Odebrecht, que se vio obligado a vender casi el 60%
de la operacin de la concesin vial Rutas de Lima.
Rutas de Lima; Gaseoducto Sur Peruano, todava no
pero se trata; Linea Amarilla, que se firm pero
todava no se cierra; H2Olmos.
os montos de transaccin promedio de las
operaciones en este sector habran superado la cifra
de ms de US$800 millones. "Hay algunas de
US$600, US$800, US$1.000",
Van a continuar algunas de estas transacciones
grandes de infraestructura que ya estamos
trabajando, pero creo que, adems, van a ver estas
nuevas (transacciones) que empiezan en retail,
energa, en minera, en agro
mrica Latina concentra el 2,3% de todas las
transacciones de fusiones y adquisiciones del mundo,
y en mensos de 3% en cuandto a vlaor de de
transascons.
Brasil lder en el mercado de fusiones y adquisiciones
durante el 2016. Durante el tercer trimestre este
pas concentr el 43% del total de los acuerdos
generados de fusiones y adquisiciones en Latinoamrica.
103 operaciones,inversin significan ms de US$14.000
millones. Mientras que peru en el trcecr trmete 18
operaciones en temrinos de inverison 65 MM doalres
Las operaciones en Per aumentaron 20% este ao
hasta 131 operaciones. El Per descendi al ltimo
lugar de las fusiones y adquisiciones (M&A, en
ingls), debido a menores valoraciones y pese al
incremento de estas operaciones el 2016. Se estn
ahciendo mas trnasacicone de empresa mediana
pero de menro vlaor
En el caso de la salud, los proyectos
gubernamentales de inversiones en Asociaciones
Pblico Privadas generan un ambiente favorable
de percepcin en los inversionistas, y adems sera
un factor dinmico en el mercado transaccional
para el prximo ao, concluy.
Del 2015:
La millonaria adquisicin de Corporacin Lindley,
comercializador de Inca Kola, por parte de Arca
Continental, se sell mediante un acuerdo, el 10 de
septiembre. La fusin y adquisicin estuvo valuada
en US$760 millones.
La firma brasilea, Votorantim, elev su
participacin en la minera peruana, Milpo, para lo
cual compr acciones por un valor de US$118,35
millones. Como agente de ventas participaron
Sociedad Agente de Bolsa, Grupo Coril Sociedad
Agente de Bolsa, entre otros.
Ennariado de Transportadora de Gas del Per en ua
fusin y adquisicin de cerca de Enagas ingres al
accionariado de Transportadora de Gas del Per en
una fusin y adquisicin de cerca de US$97 millones.
Uno de los agentes de venta fue la Corporacion
Financiera de Inversiones. (F
El Rancho lleg un acuerdo con la empresa
constructora Viva GyM, por US$49,8 millonesoto:
Andina)
La firma experta en soluciones para el mercado de
valores, Cavali S.A, se fusion con la Bolsa de
Valores de Lima (BVL) por US$38,07 millones
Aumentan las operaciones de M&A en el
pas por la mayor participacin de
extranjeros y de sectores
vinculados a la demanda interna
Las transacciones de extranjeros vienen
sosteniendo el crecimiento del mercado de
M&A peruano. A mayo se registran 58
operaciones, por US$1,595 millones, y los
extranjeros participaron en 35 de ellas (ver
grfico). El Per sigue siendo un receptor de
inversionistas, dice Daniel Hernndez,
analista de la consultora espaola TTR. Los
inversionistas de Chile, Estados Unidos y
Mxico sumaron nueve transacciones, agrega
Scotiabank anunci el cierre de la operacin de
compra de los negocios de banca personal y
comercial de Citibank en el Per, tras haber obtenido
el permiso de la Superintendencia de Banca, Seguros
y AFP (SBS) para la operacin, valorizada en US$295
millones
Creemos que esta transaccin es la mejor opcin
para nuestros clientes de banca de personal y
comercial, accionistas y empleados, y nos
posiciona para enfocarnos en nuestros clientes
corporativos e institucionales, ofreciendo mejores
servicios a travs de nuestra presencia global
1. How do you value a
company?
I know two valuation
methodologies: Intrinsic value
(discounted cash flow valuation),
and Relative valuation
(comparables/multiples valuation).
 Intrinsic value (DCF) The DCF
says that the value of a productive
asset = the present value of its cash
flows.
The iunvement horizont could be
for 5-20 years, depending on the
availabl information, and then
calculate a terminal value. It is
necessary to consider thath at the
ende of the projeccion period the
company ahs a terminal value or
liquidation value of assets.-->this can
be uequal to perpetuity of the last cash
flows of the proejeccion
Discount both the free cash flow
projections and terminal value by an
appropriate cost of capital (weighted
average cost of capital for
unlevered DCF and cost of equity
for levered DCF).
Unlever beta ahs to be asjuted for
financia leverage, becasude diffrente
comnay has tdiefrenc capital strucutres
and also the taxes rules are diffrefeen.
In an unlevered DCF (the more
common approach) this will yield the
companys enterprise value from which
we need to subtract net debt to arrive
at equity value. Divide equity value by
diluted shares outstanding to arrive at
equity value per share.
Relative valuation (Multiples):
he multiples approach is
a valuation theory based on the idea that
similar assets sell at similar prices. This
assumes that a ratio comparing value to some
firm-specific variable (operating margins, cash
flow, etc.) is the same across similar firms.
In other words, the theory is that when firms
are comparable, we can use the multiples
approach to determine the value of one firm
based on the value of another.
The second approach involves
determining a comparable group of
companies that are in the same
industry with similar operational,
growth, risk, and return on capital
characteristics. Truly identical
companies of course do not exist, but
you should attempt to find as close to
comparable companies as possible.
Calculate appropriate industry
multiples. Apply the median of
these multiples on the relevant
operating metric of the target
company to arrive at a valuation.
Common multiples are
EV/Reventreprice value to sales or
revnues, EV/EBITDA:enterprise
multiple, P/E, P/Book,price to FCF
although some industries place more
emphasis on some multiples vs. others,
while other industries use different
valuation multiples altogether. It is not
a bad idea to research an industry or
two (the easiest way is to read an
industry report by a sell-side analyst)
before the interview to anticipate a
follow-up question like tell me about a
particular industry you are interested
in and the valuation multiples
commonly used.
Comparable company analysis starts with
establishing a peer group consisting of similar
companies of similar size in the same industry
and region. Investors are then able to
compare a particular company to its
competitors on a relative basis. This
information can be used to determine a
company's enterprise value and to
calculate other ratios used to compare a
company to those in its peer group
-se relative comparisons allow the analyst to
develop an industry benchmark or average
Priece to FCF=Market capitalziaicon/FCF
If the company's valuation ratio is higher
than the peer average, the company is
overvalued
-If the company is lower than the peer
average, the company is undervalued.
Used together, intrinsic and relative
valuation models provide a ballpark
measure of valuation that can be used to
help analysts gauge the true value of a
company.
This valuation metric is calculated by
dividing a company's "enterprise value" by
its earnings before interest expense, taxes,
depreciation and amortization (EBITDA).
Overvalued undervalued
Enterpreise value
multiple=enterprise
value/EBITDA
2. What is the appropriate
discount rate to use in an
unlevered DCF analysis?
Since the free cash flows in an unlevered
DCF analysis are pre-debt is a ccompnay
cash flow before taking interest
payments into account.(think of
unlevered cash flows as the companys
cash flows as if it had no debt so no
interest expense, and no tax benefit
from that interest expense), the cost
of the cash flows relate to both the
lenders and the equity providers of
capital. Thus, the discount rate is the
weighted average cost of capital to
all providers of capital (both debt and
equity).
The cost of debt is readily observable
in the market as the yield on debt
with equivalent risk, while the cost
of equity is more difficult to estimate.
Cost of equity is typically estimated
using the capital asset pricing model
(CAPM), which links the expected return
of equity to its sensitivity to the overall
market (see WSPs DCF module for a
detailed analysis of calculating the cost
of equity).
3. What is typically higher the
cost of debt or the cost of
equity?
The cost of equity is higher than the
cost of debt because the cost
associated with borrowing debt
(interest expense) is tax deductible,
creating a tax shield. Additionally, the
cost of equity is typically higher because
unlike lenders, equity investors are
not guaranteed fixed payments, and
are last in line at liquidation.
4. How do you calculate the cost
of equity?
There are several competing models for
estimating the cost of equity, however,
the capital asset pricing model
(CAPM) is predominantly used on
the street. The CAPM links the
expected return of a security to its
sensitivity the overall market basket
(often proxied using the S&P 500). The
 formula is: Cost of equity (re) = Risk free potential range for beta). As a
rate (rf) + x Market risk premium (rm-rf result, it is recommended that we
) use an industry beta. Of course, since

Risk free rate: The risk free rate the betas of comparable companies
should theoretically reflect yield to are distorted because of different
maturity of a default-free government
bonds of equivalent maturity to the rates of leverage, we should unlever
duration of each cash flows being
discounted. In practice, lack of liquidity in the betas of these comparable
long term bonds have made the current
companies as such:
yield on 10-year U.S. Treasury bonds as
the preferred proxy for the risk-free rate
for US companies. Unlevered = (Levered) / [1+
Market risk premium: The market (Debt/Equity) (1-T)]
risk premium (rm-rf) represents the
excess returns of investing in stocks
Then, once an average unlevered beta is
over the risk free rate. Practitioners
often use the historical excess returns calculated, relever this beta at the target
method, and compare historical spreads
between S&P 500 returns and the yield on companys capital structure:
10 year treasury bonds.
Beta (): Beta provides a method Levered = (Unlevered) x [1+
to estimate the degree of an assets (Debt/Equity) (1-T)]
systematic (non-diversifiable) risk.
Beta equals the covariance between
expected returns on the asset and on
the stock market, divided by the 6. How do you calculate
variance of expected returns on the
stock market. A company whose equity unlevered free cash flows for
has a beta of 1.0 is as risky as the DCF analysis?
overall stock market and should therefore
be expected to provide returns to investors
that rise and fall as fast as the stock Free cash flows = Operating profit
market. A company with an equity beta of
2.0 should see returns on its equity rise (EBIT) * (1 tax rate) + depreciation
twice as fast or drop twice as fast as the
& amortization changes in net
overall market.
working capital capital
expenditures
5. How would you calculate beta
for a company? Levered cash flows are also known
as equity cash flows, because it values just
Calculating raw betas from historical the equity claim in the business. unlevered
cash flows are also known as firm cash
returns and even projected betas is
flows because it values the entire
an imprecise measurement of future
enterprise.I am more accustomed to referring
beta because of estimation errors (i.e. them as equity or firm cash flows thus I will be
standard errors create a large
referring to them in that format for the 7. What is the appropriate
remainder of the article. numerator for a revenue
multiple?
Equity cash flows are considered as cash
flows after debt payments and after
The answer is enterprise value.
making reinvestments needed for future
growth. The discount rate used for these cash
Equity value = Enterprise value Net
flows when preparing a DCF model is the
Debt (where net debt = gross debt
cost of equity.
Free Cash Flow to Equity = Net Income - and debt equivalents excess
CapEx + Depreciation - Change in Non- cash). For more on this equation see
Cash Working Capital +(New Debt Issues - WSPs article
Debt Payments)
at www.wallstreetprep.com/blog/.
Firm cash flows are prior to any debt
payments but after the firm has EBIT, EBITDA, unlevered cash flow, and
reinvested earnings to grow its assets. revenue multiples all have enterprise
The discount rate used for these cash flows value as the numerator because the
reflects the cost of equity and debt, also known
denominator is an unlevered (pre-
as the weighted average cost of capital
debt) measure of profitability.
(WACC).
Conversely, EPS, after-tax cash flows, and
Free Cash Flow to Firm = EBIT*(1-tax rate)
book value of equity all have equity value
- CapEx +(Depreciation + Amortization) -
as the numerator because the
Change in Non-Cash Working Capital
denominator is levered or post-debt.
In a DCF model the present value of equity
cash flows reflects only the value of equity
8. How would you value a
claims on the firm where as firm cash flows
company with negative historical
reflect the value of all claims on the firm.
cash flow?
How to Convert from Firm to Equity Cash
Flows Given that negative profitability will
make most multiples analyses
This calculation is very simple. To get from firm
meaningless, a DCF valuation
value to equity value simply subtract out the
approach is appropriate here.
market value of all debt and all other non-
equity claims in the firm.

Present Value of Debt - Market Value of

Debt = Present Value of Equity
9. When should you value a
company using a revenue
multiple vs. EBITDA?
Companies with negative profizts and
EBITDA will have meaningless
EBITDA multiples. As a result, Revenue
multiples are more insightful.
10. Two companies are identical
in earnings, growth prospects,
leverage, returns on capital, and
risk. Company A is trading at a
15 P/E multiple, while the other
trades at 10 P/E. which would
you prefer as an investment?
10 P/E: A rational investor would
rather pay less per unit of ownership
The DCF says that the value of a productive
asset equals the present value of its cash
flows. And the
La nueva planta Piura
10 Marzo, 2016
La Planta Piura es considerada como la ms
moderna de Latinoamrica, construida con una
inversin de $380 millones de dlares.impplies a
more prodcution of 5mm tons a year o cement. This
platn is 100% compuitarize this plant will Se construy
sobre un terreno de 53 hectreas, y sus instalaciones
ocupan el 50% del rea total, lo que permitir poder
duplicar su produccin en un futuro. And also it will be
able to opmtize costs and raise productos portfolio.
Aumentan las operaciones de M&A en el
pas por la mayor participacin de
extranjeros y de sectores vinculados a la
demanda interna.
Las transacciones de extranjeros vienen
sosteniendo el crecimiento del mercado de
M&A peruano. A mayo se registran 58
operaciones, por US$1,595 millones, y los
extranjeros participaron en 35 de ellas (ver
grfico). El Per sigue siendo un receptor de
inversionistas, dice Daniel Hernndez,
analista de la consultora espaola TTR. Los
inversionistas de Chile, Estados Unidos y
Mxico sumaron nueve transacciones, agrega.
Ante la creciente clase media que demanda
infraestructura y servicios no cubiertos por la
oferta local, varias empresas buscan socios
estratgicos para financiar expansiones, explica
Ins Baca, socia del estudio Echecopar. Por ello
los sectores con exposicin a la demanda
interna, como los de alimentos y servicios,
registraron ms operaciones. En el sector de
alimentos se realizaron 14 operaciones. Por
ejemplo, la estadounidense Vanguard Group y
el fondo Blue Road Capital compraron
indirectamente el 100% de Agrcola
Challapampa y de Corporacin Agrcola
Milagritos. En el rubro de servicios, el private
equity L Catterton adquiri una participacin
minoritaria de Bodytech por US$42 millones,
y en abril Inversiones Centenario y el grupo
salvadoreo Agrisal acordaron una asociacin
por S/.166 millones para construir y operar
cinco hoteles Holiday Inn Express.
En minera se realizaron siete transacciones.
Ante los menores ingresos por la cada de los
precios de los metales, algunas empresas
vendieron activos no estratgicos para reducir
su endeudamiento, comenta Borja Daz,
gerente senior de asesora financiera
de Deloitte. Las mineras apuntarn a la
transferencia de participaciones minoritarias,
pues los inversionistas no estn tan dispuestos
a ingresar a operaciones de exploracin, que
tienen perodos de recuperacin largos, aade
Baca. En abril Votorantim aument de 60% a
80% su participacin en Milpo por S/.577
millones.
En el segundo semestre del 2016, el nmero de
operaciones subira, y la venta de los activos de
China Fishery y de Odebrecht tendr un
impacto importante.
Nobel de eocnmia:mecansimo que permiten
que todasl partes implicadas en un contrato
ganen. Al resolver el problema de la
incetidumbre entre 2 partes que frima un
contrato.solucionar la simetri ade info en
un contrato con meansimos que la
solucionen, incentivo, premio al desmpeo
relativo evalua el resutlado e mpreas
similares
Entrevista de banca de inverison
La banca d inverison tinee que ver con al gestiond
e colaboradores empresariales, adquisiones,
obtencin de capital, garantas coemrciales,
fonsods de inverison.
Reiben al mayor aprte de sysu ganancias por lso
bonos que aseguran, emisin y la venta de valores
en los mercados y prestacin de aseosamiento
profesional en colaboraicones ya dquisicones.
Banca de inversin Preguntas Entrevista
Ronda de persona
* Describir algunas de sus ventajas y desventajas?
Oportundiades de mejora: 3
Uno de mis retos es mejorar la disciplina de mis
salud fsica y para ello estoy llendo mas seguido
al gym para parasa car mas cuerpo y que me
entalle mejor la ropa. Ademas de eso poner mas
atencin en mis horarios de comida y en las cossa
que ingiero.
3 otr aspecto es que anteriormente
inverta demasiado tiempo en un solo
curso pero en este ao que se dio la
oportunidad de llevar cursos pesados
con otro cruso mdeianamente fuertes
y he aprendido ser ms eficiente y a
organizar mejor mi tiempo,
estabelciendo horarios desde la hora
en que leveantaba hasta que me
acostaba y es verdadermente
sorpredente todo el tiempo que se
puede aprovechar si estabelces un
buen horario.
Terco cuando hago un trbajo en unvierad tnego
algunas ideas y trato simrpe de buxcarles
susutento y ahcerlas de determinada manera, sin
embargo comrpafno con otro compaleros me
ehfado cuenta que hay otras formas de lllgar al
mismso resultados
Fortalezas: I)perseverancia III) trabajr en eqeuipo
IV)coimprometido
* Cul es tu mayor logro en la vida?
Un gran logro en en mi exepriencai priogesional
que fue mas bien compratidio con un eqeuipod e
trbajo fue la obtencin dela buena proc ed un
proeycto comercia penitenciario.
Era un proeycto que se encargba de la
infraestrucutra epoenitneciaria, disei y
conctruccion de un nuevo penal para la ciduad de
lima a cambio de recibir el terrno del penal san
Jorge para la cosntruccion e implementacin de un
proecytocomercial compuesto pro galaerias,
vivienda estabelcimeinto comerciales)
Tanto el costo de la conturcion del neuvo penal y el
proecyo comecial era de 72 MMde doalres en un
palzo de ejcucion de 3 aos el costo del penal era
de 37 mm aproximiademente, .
Los beneficios del estado eran obtener un nuevo
totalemnte eqeuipo y con mayor segurairad,
renovaicon urbana en elc ecrdao delima,
contrubion a la formalizaion del cemrcio, y la
apmliaicond e vacante de reclusos
* Cmo hacer frente a la crtica, en el trabajo y en
la vida personal?
* Cmo hacer frente con o superar las fallas?
* Cree usted, hay un lder en ti?
* Qu tanto cree en el trabajo en equipo?
* Cul ha sido el mayor fracaso de su vida, hasta
hoy?
* Dnde te ves 5 a 10 aos por delante en su
carrera?
en tres aos haber temrniado e l prgoram del CFA
y en 5-7 aos haciendo un MBA en una buena
undiversidad de USA, continuar trbajndo en banca
d einversion.
* Por qu eligi la banca de inversin como una
opcin de carrera?
Me gusto porque
Por qu deberamos contratarte?
Porque en primeri lugar tengo enormas ganas de
aprender sobre finanzas inverisons y mecado d
ecapitales, adems porque creo que re
Me gusta citibank porque adems de ser un
empresa muntinaiconal y super concida en el
mundo de la finanzas por su calidad en la
consultoria financiera e inversiones, cme parece
que tiene un buen ambiente de trbajo que permite
un buen desarrollo profesional y personal. Tnego
amigos que practicaron enel citbank y me
comentan de uss beuenas experiencias en el
banco tanto porque predenitron bastante y porque
el ambienta laboral era bueno.
Deje mi enteorio trbajo porque sent que quera
trbajr en una mepresa mas grande y en una
entidad financeira con ello tener mayores retos y
aspiraicones de lnea de carrera.
* Cul es la definicin de xito en sus trminos?
Hacerclo que mas tegusta y ser ujo de lso mejroes
* Excepto en la banca de inversin, cules son las
oportunidades de carrera que usted est
explorando en el mercado y por qu?
gestin de pratimonios porue es una rma que
tambin me gusta, armar portafolios, ver
rentbaildiades del protafolio y mejores
delsempeos del mismso.
Sell side job description
-Is to follow comanies, all typically in the
same industry, and provide regurlar
research reports to the firms clients.
-As apart of the process, the anayst wil
typically build models to project the
frims financial results, as well as speak
to the comstumers, suppliers,
competittors and other soruces.
- the ultimate outocem of the analyst
works is a research report that is a set of
fincnial estimates, a price target and a
recommmedntaion as the stocks
expected performance.
-in practice the job of the analuyst is to
convince insititucional acoocunts to
direct their trading thorug the trading
desk of the anayst firm and the job is
aobut marketing. Tryin to be the firt to
the client with new and different
information.
-insitittuional investor will reward people
who meet with them
-it os laike a high price travel agent.
-analyst will also create expert networks
that ehy can rely upon for a constant
stream of information
Employer Employer
Fund manager Clients
Buy side analyst work for a emsion or They work fo
mutual fund, they research provide that manage
recommemdnations to the money accounts.
manager that employ them. Detmerine They offer re
investment potenctional and whteher it clients what
fits the funds strategy. the client tra
All the recomendations all exclusive receives a c
work for a pension or mutual fund Sell side ann
provide fund specific recommendations brokerage n
not to outsiders. recommenda
recommedna
to all clients
The Buy-Side Job Description
is much more about being right, ebenfiting the fund
with high-alpha iadeas is crucial, aboiding major
msitakes. Avoiding the negative is often a key part
of the buy-side analysts job, and many anaysts
purseue their job from gifuring out what can go
wrong.
Read news, tracking down information, building
models,
Buy side job description
Whereas many sell-side analysts try to spend
much of their time finding the best sources of
information about their sector, many buy-side
analysts spend that time trying to sort out the
most useful sell-side analysts. That is not to say
that many buy-side analysts do not do their own
proprietary research (the good ones always do),
rather it just means that there is significant value
to a buy-side analyst in developing a list of the
real go-to analysts in their space.
Buy-side analysts are also often indirectly
responsible for a sell-side analyst's
compensation. Buy-side analysts often have some
say in how trades are directed by their firm, and
that is quite often a key component of sell-side
analyst compensation.
Key Differences
Although both sell-side and buy-side analysts are
charged with following and assessing stocks, there
are many differences between the two jobs.
On the compensation front, sell-side analysts often
make more, but there is a wide range and buy-side
analysts at successful funds (particularly hedge
funds) can do much better. Working conditions
arguably tilt in the favor of buy-side analysts; sell-
side analysts are frequently on the road and
often work longer hours, though buy-side
analysis is arguably a more pressurized job.
Speaking realistically, sell-side analysts are paid
largely for information flow and access the
management (and/or high-quality information
sources). Compensation for buy-side analysts is
much more dependent upon the quality of
recommendations the analyst makes and the
overall success of the fund(s).
The two jobs also differ in the role accuracy plays.
Contrary to what many investors expect, good
models and financial estimates have less
weight to the role of a sell-side analyst, but can
be critical for the buy-side analyst. Likewise,
price targets and buy/sell/hold calls are not
nearly as important to sell-side analysts as
some financial media might seems to think. In
fact, sell-side analysts can be below average when
it comes to modeling or stock picks but still do
alright so long as they provide useful information.
On the other hand, a buy-side analyst usually
can not afford to be wrong often - or at least not
to a degree that significantly impacts the fund's
relative performance.
Buy-side and sell-side analysts also have to abide
by different rules and standards. Sell-side analysts
have to pass several regulatory exams that buy-
side analysts do not even have to take. Likewise,
buy-side analysts typically enjoy less restrictive
rules on share ownership, disclosures and outside
employment, at least insofar as regulators are
concerned (individual employers have different
rules concerning these practices).
The Bottom Line
Likewise, dedicated sell-side analysts can typically
dive deeper than buy-side analysts and really learn
the ins and outs of an industry. For readers
considering a career on Wall Street, though, it is
important to understand the differences and pursue
the career path that really best fits their skills and
demeanor.
Bootom- up Top D
Ambos of these approaches have the ssame goal to know s
statetegies to selecto companies in which to invest
-pasa por alto el la condiciones econmicos y sector -Involv
sino mas bien on selecting a stock base don the Look a
indidivual attirubutes of a Company. foreca
-This kind of investors simply seek strong genea
companies with good porospects regarldless(sin -Else i
iportar) of industry or macroenomic factors. indivu
Conversely(inversamente) chose
-That constitutes good prospects however is a to thei
mater of a opinion based: Ej: sup
-looking earnings growth be a d
-find companies with low Per ratios attractive. Using
-Based in these fundamentasl might
-as long as the companies are strong, the business buildin
cycle or industry conditions are of no concern. most f
chang
search
Comp
-
First of all I want to thank you for your presence
and time here.
Because I want to tell you about a very important
company in the infrastructure and construction
sector in Peru more scpecifaclly in the cement
maket
Cementos pacasmayo is a leading
As this teackir rtha t refers to common stocks
And the evolution of the ebitda and eboitda margin
% as seen in the presentation
has a clear positive tendency from 2012 to this year
and the stimation for 2017 is a major increase.
This implies that the core business remains solid
and stable with growth opponruietes. Th
In the case of revenue bars graph these have been
more volatile due to new invesmet proejects, and
as conscuences dpreciacton and financial costs like
interes
And then here is the shareholders estructure to
third quarter: 50% of shares it belongs to
invesiones ASPis, 14% to Peruvian pension funds ,
18% to ADR program
The eqeuity it is compounded by two kinfd of
stocks: common and investments stocks
General meeting of shareholders. More thant 531
MM of stocks and 50 mm of invement stocks.
A Cementos Pacasmayo ADR represents five
common shares. ADRs can be exchanged for
common shares listed on the Lima Stock Exchange
(BVL) and common shares may be exchanged for
ADRs listed on the New York Stock Exchange
(NYSE). The ADR liste in NYSE as CPAC.
In the case of ADRs. Dividends are paid in US
dollars and are subject to withholding tax in Peru
with a rate of 6.8%.
The custodian bank of Cementos pacasmayo's
ADRs is JP Morgan Chase Bank
2) now the oultlook and analystis of the industry
This table shows us how the Peruvian cement
market is divided in three regions: southern, central
and northern. As you can see the firm has been the
indisputable leader in the northern region and also
it always has obteined around 20% share of the
total market.
In the industry th egrph illustrates that cemtnos
pacsamayo hast the best ebitda margin compared
to its competence. As you can note ebitda margin is
almost the double of each competitors such as
cemex argos
This outcome can be explained because of its cost
eficent operations and also due to its focuse in the
growth of its core busness cement and cemente
related products.
3) continuing with the industry it is important to
mention that the oppotunitiy growth comes from
infreatructure gap for the next 10 years for 160
thousand oof millones of dollars. Especially in the
trasnportacion , tleecomunitcaions and energy
sectors. As it can be reflect in the raking
infreastuecut competitiecness. Peru hasa the
greater infraestrucutre deficit.
And in parallel recalling that cementos pacasmayo
contains about 20% of the cement industry
But also we should mentioned about possible risks
and mitigations
On the strength sidesit can be recalled that the
frimahas t20% market share
High levels of liquidity to afford financial costs
Baarries to entry into industry
Some weaknese is insufficient prodcutos
diversifcations, are to much focus in cement but
they are trying develop more elaboretd products.
On the opporunties side: greater prodctions and
sales to attend nortehren demdnas.
Recovery of public and private invemente
infreastructure
Threatsmdoerate levels of levaerage so future
growth depedne on capital contribution
High corrleaiton with public an privete investment
Some riks that can affect the value of the company
are:
Exchange rate risk due to debt in us dollars and the
a possible solutiocn coulb be acquire financiallt
isecurities such as cross currency swaps this are
contratcs to hedge cash flow in other currencies in
this case to hedge corproativ bonds in us dolars.
.in 2015 oss currency sswaps to razonable value
reflects changes in 2015 ha a value of 124 mm
soles and so far this year its value is aorund 82 mm
soles. This securities works as
So far this year the firm holds cross currency
contracts for a nominal vlue of 300mm de doalres
mesure in razonble value. Los saldo of this
cosntracts changes with the level of future
excahange rates.
In fact the cash flow hedge of the future payments
was considered as very effective, for this concept
the firm was able to anticipate a loss of more than
42 mm soles
Th razonable value of cross currency swaps are
measured based in market data considering a
swaps valuation models using resent value. This
models take into account different factors,
includingcredit rating of the counterparts,
currencies, foraward rates, interes rates cruves.
So far this year there has been a moderate
exchange rate volatility. This effects wre partially
mitigated by the exchange rate hedge for the
corporate bonds
But the group does na thave other financial
intruemnts to hedge the echange rate, interest rate
ormarket prices volatility sucha s carbon prices in
the market
so for the first risk it is good to consdiere a cross
currency swaps.
It allows you to exchange payment flows in one
currency determined by another flow in a different
currency.
why?
Need to hedge exchange rate risk arising from a
flow of payments in a
Unwanted currency (eg income in soles and debt in
dollars or vice versa)
Take advantage of better levels of financing than
in the conventional market (eg take a debt in soles
plus a CCS from PEN to USD as an alternative to
obtain
A better rate in dollars than taking a traditional loan)
Advantage:
It allows to set in advance the future exchange of
two payment flows in different
Eliminating the uncertainty of future exchange rates
Forwards)
Possibility of taking advantage of better financing
conditions in a given currency, taking it in a different
currency and using the cross currency swap to
exchange the flows of this debt for others in the
desired currency, obtaining better rates of financing
than the traditional alternatives
No initial cost
And benefits for a participant in such an operation
may include obtaining financing at the lower
interest rate than available in the local market,
Disadvantages:
Contractual obligation of future exchange,
eliminating the possibility of taking advantage of
More favorable market exchange rate levels
Notes:
For liquidation you can choose between the
following modalities:
Or Delivery: At each exchange date, the physical
delivery of the amounts of each flow of payments is
made.
O Non Delivery: At maturity, the delivery is made by
compensation considering the difference between
the amount paid and the amount received by the
customer
The client has a debt in soles with a rate of 7.00%
PEN that he wants to transfer to dollars.
With CCS, the client receives on each payment
date the amount in soles needed to honor his debt
(PEN 7.00%) in exchange for paying a dollar
amount that depends on the USD agreed rate
(USD 6.50%).
In net, the client has converted its debt into soles
to a debt in dollars.
The customer has a dollar debt with a 10.00%
PEN rate that he wants to spend on soles.
With the CCS, the client receives on each
payment date the amount in dollars necessary to
honor his debt (USD 7.50%) in exchange for paying
an amount in soles that depends on the agreed
PEN rate (PEN 10.00%).
In net, the client has converted its debt into dollars
into a debt in soles.
It should be spscific, it is important to note
The results of the company were in line with the
market estimates, becasue: i) no major changes in
revenues are expected, because of the additional
sales made in 3Q2015 for prevention work against
the Child Phenomenon, ii) An improvement in the
EBITDA margin is anticipated, due to the greater
efficiencies that the new Piura plant will generate.
Net income fell 20.9% in the 3Q 2016. Despite the
improvement in the EBITDA margin (33.2% vs.
31.8% in 3Q2015), there was also a greater impact
on the company due to the additional depreciation
of the Piura plant, and the interres expenses. In
result, it recommends to buy Cementos Pacasmayo
stocks because it remains under its fundamental
value around S / .7.10 (today S / .6.18) and it is
expected to raise.
The bank sells dollars at a spot exchange rate
Customer receives the dollars
Client pays in loan at doalres at a lower rate
Bank buys at forward exchange rate
Soles credit is canceled
Allows to fix in advance the future exchange of
payments in different currencies, eliminating the
uncertainty of future exchange rates. There is the
possibility of taking advantage of better financing
conditions in a given currency, taking it in a
currency and using the cross currency swap to
exchange flows
On the date of exchange the physical delivery of
the amounts of each flow of payments is made, the
spot exchange rate against the forward exchange
rate implicit in the contract is compared, and the
differential against is paid by the corresponding
party.
The forward exchange rate is defined as the
exchange rate applied to the amounts of each flow
of payments.
For the second risk should be cosndiered a and
iflation derevates like swaps iflation.
It is used to mitigate the effect of potencially large
levels of inflation. In which which a counterparty's
cash flows are linked to a price index(in this case
IPC) and the other counterparty is linked to a
conventional fixed or floating cash flow
Many investors prefer inflation protection from
derivatives because unlike inflation-indexed
bonds, a significant amount of capital isn't
required and it's more flexible. Inflation
derivatives require the buyer to provide a small
premium to the swap provider. In most cases the
Consumer Price Index (CPI) is used measure the
differences in annual inflation.
An inflation swap is a derivative used to
transfer inflation risk from one party to another
through an exchange of cash flows. In an inflation
swap, one party pays a fixed rate on a notional
principal amount, while the other party pays a
floating rate linked to an inflation index, such as
the Consumer Price Index (CPI). The party
paying the floating rate pays the inflation adjusted
rate multiplied by he notional principal amount.
For example, one party may pay a fixed rate of
3% on a two year inflation swap, and in return
receive the actual inflation.
BREAKING DOWN 'Inflation
Swap'
Investors use inflation swaps to hedge inflation
risk. A more complicated example of an
inflation swap would be an investor purchasing
commercial paper. At the same time, the investor
enters into an inflation swap contract, in which he
receives a fixed rate and pays a floating rate
linked to inflation. By entering into an inflation
swap, the investor effectively turns the inflation
component of the commercial paper from floating
to fixed. The commercial paper gives the investor
real LIBOR plus credit spread plus a floating
inflation rate, which the investor exchanges for a
fixed rate with a counterparty.
For the third problem it can be used a energy
derivate contract based in an underlying enrgy
asset in this case the carbon price it would be
feasible or possible a forward or swap contract.
Energy derivatives include exchange-traded contracts
such as futures and options, and over-the-counter
(i.e., privately negotiated) derivatives such as
forwards, swaps and options. This describes the
process used by corporations to reduce their risk
exposures to the movement of carbon prices in this
case whichs import from Colombia.t the approieta
contract for the firm would be forward
A forward contract is a customized contract
between two parties to buy or sell an asset at a
specified price on a future date. A forward
contract can be used for hedging or speculation,
so its non-standardized nature makes it
particularly apt for hedging.a forward contract
can be customized to any commodity, amount
and delivery date. A forward contract settlement
can occur on a cash or delivery basis. Forward
contracts do not trade on a centralized exchange
and are therefore regarded as over-the-counter
(OTC) instruments. While their OTC nature
makes it easier to customize terms, the lack of a
centralized clearinghouse also gives rise to a
higher degree of default risk.
a forward contract is a agreement to buy and sell
ans asst in a future day,the price for the asset is
fixed at the time the contract is assecuretd. This
contract dont trade on an exchange, also are
settle at the end of the contract term. Parties who
want to hedge th volatility inherent in the
underlying asset use forward contracts. Also are
highly costumazilble manay corporations use
them to hedge commodities. In this case the firm
uses carbosn as a mateira prima so the firm can
enter to a forward contract with a large proveedr
for example to a Colombian firm whom always
been bought the carbon, so the firm buy an
specific qeuinty and price o carbon to be
delivered in a specific date with a cash
settlement, if at the end of the contract the marke
price of carbon in colombia is higher than the
price that was settle then the company gain
profits
Prices change daily in the marketplace and are
marked to market on a daily basis.
At expiration, the buyer takes delivery of the
underlying from the seller or the parties can
agree to make a cash settlement.
The comnay is a subsidiary of inverisiones ASpi
thath pooses 50.01% of common stocks to the third
qurter.
In 16th may of this year th ecomany deicide the
dissolution of theris subsidiaria caliza del norte .
Also in 26 september is twas aprovo a escicion of
part of eqeuity pertenenciente al proeyctos fosfatos
in favor of a comnay Fossal
In order to finance proeycto salmueras the general
meetong of shsare holders of two subsisdiarias
deicide to make a contribution for more than 4
million of soles and 473 mill.
This contributions are parto of the invement
commitnment assumed for this subisdiari if the
proeyctos salmueras se lelvava a cabo hasta pro
100 MM y 14MM de diolares.
During this year there were adtions in properties,
plant equipment for more than 90 mm soles less
than thn 2015 en que als cifras were more tahtn
500 mm of soles ddruing the same period to
September 2015, durin this year or so far this year.
The financial costs because of the cosntrucction of
a new plant in pirua durin this year was 3MM
soles, considering that in 2015 the expenses were
29mmn soles.
The costos of the debt was 5% as the effective
annual costs
Eranigns per shar=net income/with average of
between commn stocks and invement stocs
outstanding.
Notticians de transasacciones

Infraestructura lider el
mercado de fusiones el
2016
Operaciones en este sector habran
movido ms de US$800 millones en el
mercado de fusiones y adquisiciones
peruano.
por ejemplo, tenemos el caso del gigante brasileo
Odebrecht, que se vio obligado a vender casi el 60%
de la operacin de la concesin vial Rutas de Lima.
Rutas de Lima; Gaseoducto Sur Peruano, todava no
pero se trata; Linea Amarilla, que se firm pero
todava no se cierra; H2Olmos.
os montos de transaccin promedio de las
operaciones en este sector habran superado la cifra
de ms de US$800 millones. "Hay algunas de
US$600, US$800, US$1.000",
Van a continuar algunas de estas transacciones
grandes de infraestructura que ya estamos
trabajando, pero creo que, adems, van a ver estas
nuevas (transacciones) que empiezan en retail,
energa, en minera, en agro
mrica Latina concentra el 2,3% de todas las
transacciones de fusiones y adquisiciones del mundo,
y en mensos de 3% en cuandto a vlaor de de
transascons.
Brasil lder en el mercado de fusiones y adquisiciones
durante el 2016. Durante el tercer trimestre este
pas concentr el 43% del total de los acuerdos
generados de fusiones y adquisiciones en Latinoamrica.
103 operaciones,inversin significan ms de US$14.000
millones. Mientras que peru en el trcecr trmete 18
operaciones en temrinos de inverison 65 MM doalres
Las operaciones en Per aumentaron 20% este ao
hasta 131 operaciones. El Per descendi al ltimo
lugar de las fusiones y adquisiciones (M&A, en
ingls), debido a menores valoraciones y pese al
incremento de estas operaciones el 2016. Se estn
ahciendo mas trnasacicone de empresa mediana
pero de menro vlaor
En el caso de la salud, los proyectos
gubernamentales de inversiones en Asociaciones
Pblico Privadas generan un ambiente favorable
de percepcin en los inversionistas, y adems sera
un factor dinmico en el mercado transaccional
para el prximo ao, concluy.
Del 2015:
La millonaria adquisicin de Corporacin Lindley,
comercializador de Inca Kola, por parte de Arca
Continental, se sell mediante un acuerdo, el 10 de
septiembre. La fusin y adquisicin estuvo valuada
en US$760 millones.
La firma brasilea, Votorantim, elev su
participacin en la minera peruana, Milpo, para lo
cual compr acciones por un valor de US$118,35
millones. Como agente de ventas participaron
Sociedad Agente de Bolsa, Grupo Coril Sociedad
Agente de Bolsa, entre otros.
de Enagas ingres al accionariado de Transportadora
de Gas del Per en una fusin y adquisicin de cerca
de US$97 millones. Uno de los agentes de venta fue
la Corporacion Financiera de Inversiones. (F
El Rancho lleg un acuerdo con la empresa
constructora Viva GyM, por US$49,8 millonesoto:
Andina)
La firma experta en soluciones para el mercado de
valores, Cavali S.A, se fusion con la Bolsa de
Valores de Lima (BVL) por US$38,07 millones
Aumentan las operaciones de M&A en el
pas por la mayor participacin de
extranjeros y de sectores
vinculados a la demanda interna
Las transacciones de extranjeros vienen
sosteniendo el crecimiento del mercado de
M&A peruano. A mayo se registran 58
operaciones, por US$1,595 millones, y los
extranjeros participaron en 35 de ellas (ver
grfico). El Per sigue siendo un receptor de
inversionistas, dice Daniel Hernndez,
analista de la consultora espaola TTR. Los
inversionistas de Chile, Estados Unidos y
Mxico sumaron nueve transacciones, agrega
Scotiabank anunci el cierre de la operacin de
compra de los negocios de banca personal y
comercial de Citibank en el Per, tras haber obtenido
el permiso de la Superintendencia de Banca, Seguros
y AFP (SBS) para la operacin, valorizada en US$295
millones
Creemos que esta transaccin es la mejor opcin
para nuestros clientes de banca de personal y
comercial, accionistas y empleados, y nos
posiciona para enfocarnos en nuestros clientes
corporativos e institucionales, ofreciendo mejores
servicios a travs de nuestra presencia global
Que es banca de inverison? En que consiste
exactamente trbajr en M&A?
Es asesoramiento financiero prestado a empresas
o fondos de Private eqeuity funciones:
1.Operaciones de compra/buy side):una
mepresa o un fondoe privete eqeuity ocntrata a un
banco de inverison para que le asesore de cara
a la adquisison de una compaa. El papale del
banco ser vlaorar la empreas objeivo para dat
una recomendaicon del rpecio que tendr que
apgar por ella
2. Operaciones de venta (sell-side): Una
empresa o un fondo de Private Equity contrata a un
Banco de Inversin para que busque potenciales
compradores de su empresa. El Banco se
encargar de comenzar un proceso de venta en
el que contactar a compradores potenciales y
ser el nexo entre comprador y vendedor
3.Bsqueda de financiacin: Una empresa
contrata a un Banco de Inversin para llevar a
cabo una operacin de financiacin. El Banco
se encargar de recomendar a su cliente la
alternativa de financiacin que ms le
convenga y ejecutar el proceso. Dentro de las
alternativas destacan: salida a Bolsa,
ampliaciones de capital y emisin de
bonos(bonds issuing)
Cuales son las salidsa profesionales
habituales? Donde peudo estar en 4 o 5 aos?
La saldida leugo de trbajr 3-5 aos en un banco de
inverison es un fonod de privete eqeuity, asesor.
Cmabiar de banco de inverison o boutique de M&A
para aplciar el conmciento en un entorno distinto.
Dentro del amplio sector de Banca de Inversin,
existen 3 posibilidades:
Banco de Inversin: son grandes instituciones
financieras que cuentan con Banca Comercial y
Banca de Inversin. La principal diferencia
respecto al resto es que tienen la capacidad de
prestar financiacin a sus clientes. Suelen tener
los mandatos ms grandes de empresas cotizadas.
La matriz suele estar en Londres o Nueva York y
tienen oficinas regionales por el resto del mundo:
Se puede dividir en:
Bancos americanos: Goldman Sachs, JP Morgan,
Morgan Stanley, Merril Lynch, Citigroup
Resto de Bancos: UBS, Deutsche Bank, Barclays,
Nomura, Socit Gnrale, etc.
Boutiques de M&A: son asesores con un foco
local que no pueden prestar financiacin a sus
clientes. Suelen tener un tamao ms pequeo
y encargarse de operaciones a nivel nacional.
Se podra dividir en:
Internacionales: Rothschild, Lazard, Mediobanca,
etc.
Nacionales: Montalbn Atlas Capital, GBS
Finanzas, Arcano, AZ Capital, 360 Corporate, etc.
Big Four: las multinacionales denominadas Big
Four (PwC, Deloitte, E&Y y KPMG) tambin tienen
sus departamentos de M&A. Suelen tener
mandatos ms pequeos que, en ocasiones,
vienen derivados de un mandato de Due
Diligence Comercial o Financiero.
Hablame de ti: 1min 30 max
-nombre
-carrera y universidad
-donde y con quien vive
-3 cosas en tiempo libre
-4 cosas imporantes que aprendiste de la
UP:
investigaciones y paper
esgadsitica y estimaciones
finanzas, bloomber e informtica
-exeriencia:
1)a veces he sido muy estricto con mis
migo mismo mis comeros y mi
temperamento se puede subir pero lo he
solucionado dialogando mejor con las
personas viendo las circunstancias y los
hechos
2)
3)
En 5 aos:funciones futros dentro de la
mepresa
-proyectos mas responsables

-empresa
Mayor fracaso:
-cargo
3 ambitos: labroal acadmico personal
-tiempo
Si se habla de algo
-funciones
bueno(fortalezas):laboral acadmico
personal
-logro
Si se hablad ealgo
3.bloque:
malo(debilidades):personal acadmico
-responsable laboral

-intuitiva Fijarse en el aprendizaje como lo sluciono

mas tiempo al desarrollo y aprendizaje.
-trbajar en eqeuipo
Mi aspiraicon salarila es del tanto pero
Fortalezas: hablar de esas con 1 solo depneidendo de mis resnsabildiades
ejemplo que actue de una forma ante puedo considerarlo
estimulo, resultado. Ostrar las 3
fortalezas. 1min 30

1)

2)

3)

Debilidades:

BVL. El Rally la salv de ser
frontera? 5 de mayo
Pasar de ser una bolsa poco atractiva y al borde de una
reclasificacin a mercado frontera por parte del MSCI (SE 1483,
1489, 1490) a ser la segunda bolsa ms rentable del mundo
despus del Bovespa de Brasil en slo dos meses parece un
milagro, y efectivamente lo fue. Hasta febrero la gran mayora de
los actores del mercado local se mostraba pesimista frente a
la BVL (SE 1503) ante un panorama desalentador por una
suma de factores internos y externos: el alza de las tasas de
la Fed, el fenmeno de El Nio, las elecciones, la
desaceleracin econmica y los precios deprimidos de los
commodities. No haba ningn catalizador de retorno al alza a la
vista. () Oportunidades Hay oportunidades despus del rally?
S, pero los analistas recomiendan ser selectivos y enfocarse en
acciones de demanda interna, dadas las perspectivas ms
positivas sobre la economa. "Ahora es ms difcil encontrar
papeles con potencial de apreciacin, pero nos gustan los que
estn ligados al consumo", seal Fernando Iberico, nuestro
Analista Senior de Estrategia y Estudios Econmicos.
puesta por el Mila
Renta4 Banco, con sede en Espaa, lanz su fondo MILA, que
concentrar el ...
Renta4 Banco, con sede en Espaa, lanz su fondo MILA, que
concentrar el 75% de su Inversin en renta variable de los
pases de la Alianza del Pacfico: Per, Chile, Colombia y
Mxico. Con ello la firma espaola avanza en reforzar su
presencia en el bloque, donde ya cuenta con operaciones en
el Per, Chile y Colombia. Para finales de este ao abrir una
oficina en Mxico. El fondo apuesta por las acciones ms lquidas
de la Alianza del Pacfico, representadas en el ndice S&P
Pacific Alllance Select Index, que ha rendido 10% en lo que va
del ao. Entre ellas figuran las peruanas Credicorp y Southern
Copper Corp. El fondo MILA ser el primero en su tipo
gestionado por una entidad europea: Renta4 Luxemburgo. Segn
un informe nuestro reciente informe, el MILA se ha visto impulsado
en los ltimos dos meses por una menor aversin al riesgo
ante los mejores resultados de las economas desarrolladas.
Las acciones ms negociadas del MILA en febrero fueron
Enersis (Chile) y Ecopetrol (Colombia).
Portaoflio:
Una estrategia pasiva replcia lo que ya exste y sobre
la abse de lo que ya existe genera una rentbailidad.
Una estrategia activa quiere gnarle al emrcado y
sobrepondera acciones o inlcuyeacciones disitntas
con mayor riesgo.
1)estrartegia pasiva vs estrategia activa
Retorno totoal de portafolio o accion= R+ prima de
mercado+ alpha: retorno extra por encima del
mercado
R+prima de emrcado=estrategia apsiva que trata de
capturar e retorno esperado dado un niveld e riesgo
de portaoflio.(sea consistente con un nivel de rirsgo
del portaoflio). Lo que compres o o que repliques
debe ser consistente con el nivel de riesgo de l
cliente. A acptar con ello replico el portaoflio. Luego
hago un reblanzce para modificar los pesoso de los
montos invertidos en secuirties que estoy
replicando.Que sea consistente con un veile de
riesgo del protafolio.
Cuando se habla del aphas e habla de una estrategia
activa dada por ganarle al emrcado. Contrayendo
portafolios capcaes de producir retonros que
exceden los retonros esprados ajsutados por
reriwsgos.
La estrategia pasiva mantiene acciones que hacen
que el retorno del protafolio haga track del
protafolio becnchmark. Tambin llamado indexing
no es parte del objetivo genera alpha.
La estrategia activa es un intento activa es un
intento del gestor de superara un benchamark de
acciones ajsutado pro rrisgo:
-ajsutes tcticos:
-selecciond eactivos:seccuirty selection
2) Estrategias de gestin de protafolios de RV
Tracking error: volatilidad del reronro de un
protafolio respecto de su ebnchmark
RPT: retorno portafolios en t
Rit: rentabilidad activo i en t (en portafolio)
Rbt= retorno de benchmar en t
Wit: peso activo i en el portafolio
Para una meustra T obs, la varinza del cambio en el
tiempo
RPT=Zi=1,N wi Rit
%t=Rpt-Rbt
Para una muestra de T obs, la varinza del %t
Varianza (%)=
Instrumentos derfivados:
Isntumento cuyo precio deriva del precio de otros
activos.
2)forwards
El principal reisgo es el incumplimiento(default) o
de contrato
Contato t=0 y se reliza en el futuro T=t
En el not delivery no hay entrga del subyacente sol
Full delivery, te dan el activo subyacente que
vendeinedoleo en ele mrcado de ta gnancias.
5 deiciones importantes:
1)Deiciond einverison de cpaitla:capex
2) Gestin de capital de trbajo:admiistra
efectivo inventarios cxc para crear valor
3)Valoraicon de mepresas
4)Nivel de endudameinto:estructura de
capital
5)Cuanto dividnedno o que cantidad y que
frecnuecia, declaraicon a los inverisonistas
ue se va repartir dividendos trimestral
anual.
Poltica de dviiendnos:
4 practicas:
-reparto de diveindndos en efectivo
-Reparto en acciones: Por cada accin que
tien un accionesta recibir una fraccin de
accin.(acciones liberadas:por cada 4
acciones recibe una accin) en acciones
-recompra d acciones: puede indicar que la
accin esta depreciada.
3 frmas de die vesittures:
-stock plit: par aumentar la liquidez de
acciones es una particin accionario, la
cpaitlaizicon burstil no cmabia.
100*10=1000
200*5=1000
-es la venta de una unidad e negocio peude
srr una porcin minoriata o mayoriatariiia.
I es minoriataria es un equity carve-out:
venders una propocion unitaria de negocio
pero sigues con la psocion mayoriataria
Spin out_: te quedas con una psoicon
minoritaria y vendeas la mayoriataria son
ventas de unida de negocio
Le das la opcin al que comrpa las acciones
que intercambia unas acciones con la
accines de la empresa que vendekk
Cato mas capital concentrado tenia la
compia menso posibilidad tenia la
compaa.
4 pregntas sobre poltica de dividendosa
1)deben ser altos o bajos:
2)estables o irregulares:
3])detemrino la frecuencia: de anunciar la
politia la merado o no: es buena noticia par
los accionistas: entonces la accin sube. Deb
cumplir sino riesgo de discrcion. Si cmabias
la opcionde a promesa la ccion cae.
4)debera ser anunciada la polticia:
Para una empresa epequea que reparte
dividendos es mala noticeia porque not ien
proeeycts rentbales en lugar de repartir
dividendos.
Is las mepresas tienen mas ebenficios van a
comrpara acciones, si el rpecio no cmabia y
la mepresa tiene mas ebenficios la empresa
esta subvaluada.
Rarios importantes del pago de diviendos:
Didinden pay put= dididnedos/NI, cuando se
paga ams del 100% de dividndos pay out:
para mantenr el rpeico de la accin.se presta
plata para pagar dividendos por que
proemdio pagara dividiendos o cierto monto
de divindos.
Didinde yield = diiv/pricerd
Retention ratios: = 1-divi/NI=1-d
Cada empresa debe deicsdir su polticia de
dividndedos particular
Finanzas
Ocho consejos
para emprender
desde cero
Mircoles, 20 de agosto del 2014
En Per, la gran mayora de las unidades
empresariales sonpymes que un da decidieron
iniciar su propio negocio quizs siguiendo algunos
de estos tips de Mastercard.
Segn datos de la Sociedad Nacional de
Industrias(SNI), el 96% del tejido empresarial en
el Per est conformado por pequeas empresas,
mientras que el otro 4% se lo dividen casi en partes
iguales las medianas y grandes empresas.
Es importante que consideres que el xito est
ligado al desempeo de las personas que estn a
cargo del proyecto, lo llevan adelante, lo organizan
y lo hacen competitivo, dijo la empresa
de tarjetas de crdito y dbito, Mastercard, en
un comunicado.
Emprende ahora
1.- Determine cul es su pasin o mejor
habilidad.Detecte y elija correctamente su mejor
habilidad y concntrese en ella; busque
especializarse y capacitarse de forma permanente.
2.- Realiza un plan de negocio. Disee su plan
tan rpido como pueda, pues ser su carta de
presentacin y su brjula, adems que ser de
ayuda a la hora de buscar inversionistas.
3.- No tema equivocarse. La mayor parte de las
empresas han cometido errores, por ello no tema
fracasar, ya que estas experiencias le
proporcionarn el aprendizaje necesario para
convertirse en un emprendedor exitoso y le
permitirn saber que va por el camino correcto. Si
se equivoca, vuelva a comenzar.
4.- Focalice. Nadie sabe de todo, todo el tiempo.
Por ello, es fundamental posicionarse en su mayor
habilidad y no distraerse innecesariamente, pues de
esta forma evitar perder tiempo, dinero y calidad.
5.- Persista. Con ayuda de la perseverancia
cosechar recompensas.
6.- Controle sus finanzas. El futuro financiero
de su empresa depende del grado de desarrollo en
la gestin de sus finanzas. Puede parecer obvio,
pero es importante conocer los ingresos y egresos
de su negocio. En el sitio de Consumo Inteligente
de Mastercard est disponible una herramienta
muy apropiada y de fcil comprensin, que puede
bajar desde aqu.
7.- Capactece. Hgalo, pues es necesario si no
est familiarizado en el mundo de los negocios.
8.- Confe. Los emprendedores constantemente
estn tomando decisiones y asumiendo riesgos, por
lo cual es fundamental que tenga confianza.
Alguien dijo forex?
stoy seguro que gran parte de ustedes han sido
contactados en algn momento por ejecutivos
de inversiones de brkeres que te ofrecen
invertir en el mercado de divisas (tambin
conocido como forex o FX). En mi caso lo han
hecho varias veces por diferentes medios,
presentndome el producto como novedoso y
sumamente lucrativo. Bueno pues, no todo lo
que brilla es oro, y por ello me anim a darles
mayor detalle acerca de este producto, desde
cmo est estructurado en el
mercado retailhasta cules son los riesgos y
recomendaciones que les puedo dar.
Un poco de historia.El mercado de divisas
se cre inicialmente como soporte para el
comercio internacional. No obstante, con el
pasar del tiempo este mercado se empez a
relacionar ms con el mercado de activos
financieros, dejando de estar vinculado al
sector real. Entre sus principales caractersticas
estn:
Es el mercado ms grande y lquido
del mundo, con un monto
 negociado promedio diario de
US$5 billones
Los principales participantes de
este mercado son los bancos,
quienes negocian entre s ms del
50% del volumen diario
Pertenece al denominado mercado
profesional, siendo sus operadores
personas altamente especializadas
No se trata de un mercado
centralizado, es decir, en este
mercado las partes negocian
directamente y se liquidan entre
ellas. Esto implica que existe un
riesgo de contraparte y los precios
no son nicos
El ingreso al mercado retail. Cmo
lleg este mercado altamente profesional al
segmento retail? La Internet tiene mucho que
ver en esto. Hacia finales de los noventa este
mercado empez a venderse como alternativa
de inversin para personas, principalmente en
Europa. Las claves del xito para su expansin
fueron la posibilidad de apalancamiento
elevado que permita una inversin inicial
pequea, la conexin en tiempo real a los
mercados relevantes, la facilidad para abrir una
cuenta, entre otros aspectos.
Recuerdo que hace un ao me anim a ir a una
de las charlas de estos brkeres. Mi inters
principal era saber cul era el speech y qu
pblico objetivo iba a las conferencias. Para mi
sorpresa, el auditorio estaba lleno de personas
de diversos perfiles: estudiantes, retirados,
profesionales, seoras, etc. Al escuchar las
conversaciones de las personas a mi alrededor
saqu un primer perfil: muchos hablaban de
cmo haban ganado o perdido dinero en las
mineras juniors dentro de la BVL. Notan
algn parecido? Otro aspecto que me preocup
era la baja comprensin del pblico sobre el
mercado de divisas, lo cual era afianzado por la
manera que tenan los ejecutivos del brker de
venderlo: nunca se mencionaban los riesgos, ni
que era un producto operado principalmente
por el mercado profesional. El discurso central
giraba en torno a que era una forma fcil y
sencilla de lograr rentabilidades sumamente
elevadas con poco capital inicial.
Sabes cmo opera este
negocio? Estoy seguro de que muchos de
ustedes ignoran cmo se estructuran estos
negocios y el porqu cada vez ms brkeres
ingresan al mercado peruano. Veamos de
manera sencilla algunos tipos de brkeres de
FX y sus caractersticas.
Los Straight Through Process
(STP) y los Electronic
Communications Networks
(ECN) Brokers. Estos brkeres
conectan directamente las
operaciones de sus clientes con los
denominados prime
brokers, quienes son mayormente
bancos de inversin o bancos
comerciales grandes que proveen
su mercado de divisas para los STP
y ECN. De esta manera el brker le
brinda al cliente la mejor compra y
la mejor venta de su prime, y en
algunos casos, le brinda
profundidad de mercado (libro de
demanda). Lo importante aqu es
que el brker no asume mayor
riesgo, pues sirve como
intermediario, por lo cual cobra
una comisin.
Market makers. Son creadores
de mercado, es decir, toman
posicin propia para poder vender
o comprar segn las operaciones
de sus clientes. Ellos mismos
proveen el precio de compra y de
venta para cada par de monedas.
El punto a tener en cuenta aqu es
que cada cliente opera contra el
brker, con lo cual ste asume un
riesgo mayor. El problema es que
algunos de estos brkeres no
tienen posicin real, o sta es
mnima, lo que significa que
su stockcomo creadores de
mercado parte de las posiciones de
sus propios clientes. En estos
casos, el modelo de negocio
funciona en la medida que las
ganancias de los clientes sean ms
que compensadas por las prdidas
de los mismos.
Hbridos. Son una mezcla de los
dos anteriores, lo que significa que
pondrn a sus clientes en la
 plataforma que ms les convenga.
En su mayora, el cliente empieza
bajo el modelo de market
markers. Conforme el broker se va
dando cuenta que el cliente est
ganando dinero sistemticamente
(lo que significa que el brker est
perdiendo), lo podran pasar al
mercado profesional (STP, ECN)
para evitar perder ms dinero. Si
alguno de ustedes ha estado en
estas plataformas ganando dinero
y de repente le han hecho unup
grade hacia otra plataforma, ya
saben realmente lo que podra
estar pasando detrs de
bambalinas.
Modelo de negocio. La fuente principal de
xito de los brkeres en este mercado es tener
la mayor captacin de nuevos clientescada
mes. Recalco nuevos porque deben compensar
la salida de clientes, la cual usualmente es
elevada (rotacin) debido a que buena parte
pierde dinero. Tengo entendido que en
promedio los ejecutivos comerciales de estos
brkeres en el Per tienen por meta captar
alrededor de US$100,000 mensuales en
nuevos clientes.
Esta alta rotacin necesaria crea un riesgo
importante: en el momento que dejen de
ingresar clientes nuevos, la cadena de pagos
podra romperse y el negocio entrara en
problemas. Esto no sucede con otros
intermediarios, por cuanto la rotacin de
clientes no es tan alta y stos operan contra el
mercado centralizado directamente (por
ejemplo, las SAB).
Diversificando el negocio. Como es tan
buen negocio, estos brkeres a nivel mundial
no slo se limitan a operar FX, sino tambin
otros activos, como acciones, bonos
o commodities. No obstante, estos activos se
transan bajo la figura de Contract for
Difference (CFD), que de novedoso y
revolucionario no tienen nada, pues se crearon
a inicios de los noventas. Estos contratos son
parecidos a los Non-Delivery Forward (NDF),
es decir, se liquidan por diferencias entre el
precio de compra y venta del activo subyacente,
lo cual te permite obtener ganancias (o
prdidas) sin poseer el activo.
Es justamente este tipo de instrumento (CFD)
el que le permiti al conferencista que escuch
repetir de manera sistemtica que ellos no
transaban valores (activos financieros), sino
slo contratos por diferencias. Ello es verdad,
porque cuando compras una accin de Apple
por estas plataformas, realmente no tienes la
accin, sino slo ests apostando sobre el
diferencial entre tu compra y tu venta. Esto
justamente es lo que les permite a estos brokers
operar libremente sin necesidad de regulacin.
Y dnde est el regulador? Las
historias de estafas de estos brkeres a nivel
internacional son innumerables. Ojo, no estoy
diciendo con ello que este mercado sea una
estafa, sino que como todo, tiene sus
participantes serios y los no tan serios, por
decir lo menos.
Algo que resalto positivamente es la
determinacin con la que han actuado en este
mercado los reguladores en Europa y US. Por
ms que no pueden supervisar directamente las
operaciones, al menos han tratado de reducir
los riesgos en busca de proteger a los
inversionistas. As, por ejemplo, en estos
pases se cuenta con un fondo de seguro
en caso de quiebra y un patrimonio
mnimo para estos brkeres. No obstante, la
regulacin va a depender de dnde est
constituida la empresa. En este mercado
abundan los brkeres que se constituyen en
parasos fiscales de baja regulacin, con lo cual
tiene mayores grados de libertad en sus
operaciones internacionales.
Por ejemplo, los brkeres que operan en el
Per estn constituidos en su mayora
localmente como empresas que brindan
servicios de asesora empresarial, no
requiriendo supervisin ni regulacin alguna.
Mientras que sus casas matrices estn
constituidas usualmente en parasos fiscales
con baja o nula regulacin. Esto me parece una
figura muy cuestionada, la cual crea una
competencia desleal frente a otros
intermediarios del mercado local.
Qu les recomiendo? Mi recomendacin
principal es que si quieren invertir
profesionalmente en el mercado de divisas,
acciones, bonos, etc. acudan a los mercados
centralizados. Estos mercados son regulados,
tienen precios nicos, tienen cmaras de
compensacin y custodios, entre otros
aspectos. Incluso cuentan con plataformas
profesionales para operar en lnea. Obviamente
esta mayor seguridad se refleja tambin en las
comisiones (que realmente no son tan
onerosas), pero dejemos de ser peseteros y
empecemos a tomar decisiones profesionales
con nuestro dinero. Para los que desean
apalancarse, el mercado de futuros te deja
operar hasta 50:1, pero cuenta con un sistema
de reposicin de garantas diarias en caso tu
posicin est en negativo (margin call). Esto
disminuye el riesgo de la operacin entre las
contrapartes.
En caso tercamente estn decididos a entrar al
mercado no regulado de FX, permtanme
darles algunas recomendaciones bsicas:
Eviten brkeres que estn
constituidos en parasos fiscales. Si
el brker est constituido en el
Per deben exigir que al menos
sea una Sociedad Intermediaria de
Valores (SIV), que est regulada
por la SMV. Si mencionan que sus
operaciones en Per son
comerciales, pidan que les digan
en qu pas est su matriz o su
brazo financiero. Tambin es
importante saber si su casa matriz
est regulada por la NFA (Estados
Unidos), FSA (Reino Unido), Finma
(Suiza), o averigen la rigurosidad
que tiene el ente regulador que
corresponda. Pregunten si existe
algn seguro que los proteja ante
una potencial quiebra de la
empresa.
La ejecucin de las rdenes
tambin es un tema importante. En
algunos casos, cuando quieres
poner una orden, de repente el
sistema se cuelga o no la
transmite. Esos pequeos
segundos de intervalo pueden
significar mucho en una operacin
apalancada. Incluso algunos
brkeres utilizan esta
maniobra para evitar que los
clientes compren o venda
realizando fuertes ganancias (es
decir, prdidas para los brkeres).
Evitar el apalancamiento excesivo.
Considero que este punto est
comercialmente mal manejado (o
bien manejado para los brkeres).
Como te ofrecen una palanca de
hasta 500:1 la probabilidad que
pierdas tu dinero es alto.
Recordemos que este mercado es
para profesionales, lo que significa
que si alguien con conocimientos
bsicos lo opera, es ms que
seguro que va a perder su dinero.
Al slo hacer nfasis en la
posibilidad de retornos elevados
sin exponer los riesgos, el
inversionista inocente puede verse
perjudicado. Yo me pregunto, no
debera el Indecopi regular
este tema?
Tengan cuidado con los regalos o
bonos. Muchas veces estos
regalos vienen con letras
pequeas. A veces sirven como
candado para que no puedas sacar
tu dinero rpidamente.
Recordemos que uno de los
grandes riesgos que tienen estos
brkeres es la alta rotacin de sus
clientes, lo cual los lleva a buscar
barreras a la salida.
Averigen el tipo de brker. A nivel
de riesgos es mejor tratar con
brkeres que sean STP o ECN, pues
se evita el conflicto de inters visto
anteriormente. Esto no significa
que todos los que sean STP o ECN
sean de confiar, ni que los que
actan como market makers no lo
sean, pero es bueno saberlo antes
de invertir.
Les reitero que este mercado NO es para las
personas, es un mercado profesional. No es un
juego invertir con una palanca de 400:1, por
ms que te digan que no vas a perder ms de lo
que invertiste (que igual sera una prdida de
100%!). Me parece que la estrategia comercial
de estos brkeres no es la adecuada, porque
estn captando a personas que no tienen idea
del nivel de riesgo de este mercado, y se les
endulza diciendo todo lo que podran ganar.
Recuerden, NO existe el dinero fcil!
Para terminar, hago un llamado a los
reguladores y supervisores del mercado (SMV,
Indecopi, Sunat, entre otros). Espero que en
algn momento tengan la determinacin de
entrar en este mercado como lo han hecho sus
pares de US y Europa. No esperemos que
suceda algo negativo para recin empezar a
quitarse la venda que se han puesto en los ojos.
Qu es un hedge?
Para que le vaya bien no es necesario que acierte
todo el tiempo, ni siquiera la mayora de las veces.
Peter Lynch
En la jerga comn de los especuladores comprar
significa tomar posiciones largas en un activo y ganar
si el precio de este activo sube de precio. Vender
significa tomar posiciones cortas en un activo y ganar
si el precio de este activo baja de precio. Por tanto, en
los mercados globalizados y con tantas herramientas
financieras a nuestra disposicin se puede rentabilizar
tanto en tendencias alcistas o bajistas de los
mercados.
Por que explico ello? Para poder conceptualizar el
concepto del Hedge. Hacer un hedge significa
eliminar el riesgo de una transaccin. Por ejemplo,
imagine a un inversionista que tiene posiciones largas
(de compra) en acciones y otra cantidad adecuada de
posiciones cortas ( de venta) en un indice de acciones,
con ello protege el valor de su cartera contra una cada
general del mercado de acciones.
Hedge fund
No hay una definicin especifica para un hedge fund.
Segn un informe de los reguladores de finanzas de
USA, un hedge fund es cualquier instrumento de
inversin colectivo que esta organizado de forma
privada , administrado por administradores
profesionales y no disponible para el pblico en
general. Brilla por su ausencia el concepto de
cobertura no?
El primer hedge fund se cre en 1949 y buscaba
asegurar una cartera de acciones contra perdidas
mediante la tenencia simultnea de posiciones largas
como cortas, con una estrategia definida claro,
especulando quiz con la subida de los mercados, pero
protegiendo los retornos generales del fondo si
hubiera cadas significativas en los mercados.
Las caractersticas principales de un hedge fund son
las elevadas comisiones por gestin y el uso del
apalancamiento.
En general, un hedge fund cobra una comisin de
gestin anual de 2% en promedio del valor del fondo y
una comisin por desempeo que puede superar el
20%. en contraposicin un fondo mutuo suele cobrar
no mas de 1,5% anual sin comisin de desempeo.
Hasta aqu, todo claro espero, la otra caracterstica de
importancia del hedge fund es el apalancamiento, la
posibilidad de realizar inversiones superiores al valor
del fondo inicial, ello magnifica los retornos de los
fondos -tanto las ganancias como las perdidas- y
justifica de alguna manera el desempeo en general
exitoso de algunos fondos en los ltimos aos.
Alpha
La existencia de este trmino esta abierta a la
discusin, aunque estadsticamente existe. La
importancia del alpha es que estadsticamente puede
usarse para cuantificar la medida en la cual un
administrador de fondos agrega valor a la cartera que
esta administrando. Obviamente ello es significativo,
cuanto mas se puede demostrar que un administrador
agrega valor al fondo, mas querrn los inversores
colocar su capital en dicho fondo.
Alpha es especialmente importante para los
administradores de Hedge funds, la dificultad radica
en su medicin. Alpha es el subproducto de una
ecuacin de regresin de mnimos cuadrados que
busca ajustarse a una linea recta para mostrar la
tendencia de una dispersin de puntos en un grfico.
Por ejemplo, un fondo puede tener un alpha elevado
cuando sus retornos se grafican contra los retornos de
un mercado de acciones , pero podra ser muy
diferente si lo comparan contra el alpha de otros
hedge funds.
Espero que con esta breve explicacin hayan quedado
ms claro estos conceptos que normalmente leemos a
diario. Les informo que este da viernes 19 de julio a
las 10:00am realizar una Conferencia ONLINE
gratuita sobre Perspectivas de los mercados y
oportunidades de inversin, pueden registrarse en
info@forexperu.pe.
Contrato forward
Un forward, como instrumento financiero derivado,
es un contrato a largo plazo entre dos partes para
comprar o vender un activo a precio fijado y en una
fecha determinada. La diferencia con loscontratos de
futuros es que los forward se contratan en
operaciones over the counter es decir fuera de
mercados organizados.
Los forwards ms comunes negociados en las
tesoreras son sobre monedas, metales e
instrumentos de renta fija.
 Existen dos formas de resolver los contratos 2.1.1.1Valoracin de los
de forward de moneda extranjera: compromisos a tipo Fijo

Por compensacin (non delivery forward): al 2.1.1.2Convencin para

vencimiento del contrato se compara el tipo de el Factor de descuento
cambio spot contra el tipo de cambio forward, y el
diferencial en contra es pagado por la parte 2.1.1.3Valoracin de los
correspondiente. compromisos a tipo Variable

Por entrega fsica (delivery forward): al 2.1.2Valoracin de un swap a

vencimiento el comprador y el vendedor tipo fijo/variable. Valor total del swap
intercambian las monedas segn el tipo de
cambio pactado 2.1.3Relaciones que podemos
establecer a partir del NPV de un swap

Swap (finanzas) 2.1.4Ejemplo de valoracin de

un swap en el tiempo. Resultados, valoracin
y liquidaciones del swap
Un swap, o permuta financiera, es un contrato por
el cual dos partes se comprometen a intercambiar
o 2.2Negociacin de un swap
una serie de cantidades de dinero en fechas futuras.
Normalmente los intercambios de dinero futuros estn
o 2.3Concepto de cotizacin o Pricing y
referenciados a tipos de inters,
cobertura o Hedge de un swap
llamndose IRS (Interest Rate Swap) aunque de
forma ms genrica se puede considerar
o 2.4Otras consideraciones sobre un
un swap cualquier intercambio futuro de bienes o
swap
servicios (entre ellos de dinero) referenciado a
cualquier variable observable. Los swaps se
o 2.5Otros swaps de tipo de inters
introdujeron por primera vez al pblico en 1981,
cuando IBM y el Banco Mundial entraron en un
2.5.1Swap Fijo vs Fijo o
acuerdo de intercambio. Un swap se considera un
Variable vs Variable
instrumento financiero derivado.
2.5.2Asset Swap
ndice
[ocultar] 2.5.3Call Money Swap

1Conceptos 2.5.4Constant Maturity Swap

o 1.1Partes de un swap o 2.6Swaps de tipo de inters en

diferentes divisas
o 1.2Representacin grfica de un swap
3Ejemplos de otros tipos de swaps
o 1.3Valor de un swap
o 3.1Swap de divisas
1.3.1Cmo valorar un swap?
o 3.2Equity Swap
o 1.4Utilidad de un swap
o 3.3Total Return Swap
2Swaps de tipo de Inters
4Vase tambin
o 2.1Swaps de tipos de inters de tipo
variable vs tipo fijo 5Bibliografa

2.1.1Valoracin de un swap a 6Enlaces externos

tipo fijo/variable. Descomposicin
Conceptos[editar]
Partes de un swap[editar]
Dado que es un compromiso de intercambio de
dinero a futuro, un swap tiene dos partes, una para
cada uno de los contratantes: el compromiso de
cobro de dinero a futuro y el compromiso de pago de
dinero a futuro.
Representacin grfica de un swap[editar]
Para una de las partes un swap grficamente se
puede representar de la siguiente manera
Donde se producen para una de las contrapartidas
una serie de flujos de cobros y una serie de flujos de
pagos desde el momento inicial del contrato (t=0)
hasta su vencimiento (t=v). Lgicamente, lo que para
una de las partes son derechos de cobros son
compromisos de pagos para la otra y viceversa.
Valor de un swap[editar]
Como cualquier contrato o compromiso de flujos de
dinero un swap debe tener un valor econmico. El
valor econmico del swap, si es determinable,
reflejar en cualquier momento del tiempo la cantidad
a pagar o recibir para entrar o salir del contrato en
funcin de en que lado del compromiso estamos
nosotros.
Cmo valorar un swap?[editar]
Dado que un swap se corresponde de unos
compromisos de flujos futuros de cobro y de pago,
para hallar su valor debemos valorar esos
compromisos futuros. Usaremos la tcnica
del arbitrajepara valorar los compromisos futuros.
El arbitraje consiste en replicar los flujos del swap
mediante instrumentos simples de forma que la
agregacin de la valoracin de los instrumentos
simples ser el valor econmico del compromiso en
su conjunto. El valor econmico (VE), pues, lo
podemos expresar como:
Esta expresin recoge la suma del valor en el
momento inicial de los compromisos futuros que
incorpora el swap. Un valor de positivo supone un
compromiso de cobro y un valor negativo supone un
compromiso de pago. El valor VE puede ser positivo,
negativo o cero. Si es positivo supone que "a fecha
de hoy" la valoracin de los compromisos futuros de
cobro es mayor que los compromisos futuros de
pago. Es importante entender el concepto de valor a
fecha de hoy. Aunque el valor a fecha de hoy de los
cobros sea mayor que el valor de los pagos no
significa que cuando pase el tiempo cobraremos ms
que lo que pagaremos, llegando a ser posible la
situacin inversa. Este concepto se entender mejor
con el ejemplo. El valor a fecha de hoytambin es
conocido como Valor Actual(VA) o NPV (abreviacin
del ingls "Net Present Value"). En adelante
llamaremos indistintamente VA=VE=NPV.
Partiendo de la base de que el valor actual del los
flujos del Swap en el momento de la compra debe
ser cero, de manera que la transaccin sea justa
para ambas partes se presentan dos situaciones:
Cuando el NPV es positivo, deberemos pagar
a nuestra contraparte el NPV para entrar en
el contrato de swap
Si el NPV es negativo, nuestra contrapartida,
nos pagara el NPV
En funcin de la variable a la que se referencien
los cobros y pagos futuros la funcin Error al
representar (MathML con SVG o PNG
como alternativa (recomendado para
navegadores modernos y herramientas
de accesibilidad): respuesta no vlida
(Math extension cannot connect to
Restbase.) del servidor
/mathoid/local/v1/:): \varphi ser
diferente. Esto significa que los instrumentos
simples que utilizaremos para calcular el valor
econmico por arbitraje (NPV) sern diferentes
en funcin de cada variable a la que se
referencien los flujos.
Utilidad de un swap[editar]
Bsicamente podemos hablar de dos utilidades o
motivos por los que tendremos inters en entrar
en un swap:
a) Cambiar nuestros bienes o recursos futuros:
Puede interesarnos para nuestro negocio
intercambiar durante un tiempo bienes o recursos
que generaremos por otros bienes o recursos
necesarios para nuestra actividad o bienestar.
b) Especulacin: Al igual que la especulacin en
otros activos, entraremos en un swap si nuestra
visin es que los bienes que recibiremos a futuro
van a suponer para nosotros mayor valor que los
bienes que entregaremos a futuro.
Swaps de tipo de
Inters[editar]
Hemos comentado que un swap puede
referenciarse a cualquier tipo de variable
observable. As los compromisos de cobro y pago
de las dos partes del swap pueden referenciarse
a diferentes variables (por ejemplo, tipos de
inters, precio del petrleo, precio de la vivienda,
cotizacin de una accin, etc). Los swaps ms
simples y conocidos en los mercados financieros
son los swaps de tipo de inters. En estos swaps
cada parte est referenciada a diferentes ndices
de tipo de inters.
Swaps de tipos de inters de tipo variable
vs tipo fijo[editar]
Los swaps fijo/variable se pueden definir como el
compromiso por el que una parte paga/recibe un
tipo fijo sobre un nocional prefijado y recibe/paga
un tipo variable sobre un nocional prefijado .
Normalmente Error al representar (MathML
con SVG o PNG como alternativa
(recomendado para navegadores
modernos y herramientas de
accesibilidad): respuesta no vlida
(Math extension cannot connect to
Restbase.) del servidor
/mathoid/local/v1/:): {\displaystyle
N_1=N_2=N} . El nocional es la cantidad sobre
la que se aplicar el tipo de inters (el nocional
tambin se suele llamar nominal). Un ejemplo en
detalle de cmo se definira un contrato de swap
fijo variable sera como sigue:
Fecha de inicio: 20 de julio de 2008
Fecha de finalizacin: 20 de julio de 2011
Contraparte que paga fijo recibe variable: A
Contraparte que recibe fijo paga variable: B
Nocional(Error al representar (MathML con
SVG o PNG como alternativa (recomendado
para navegadores modernos y
herramientas de accesibilidad): respuesta
no vlida (Math extension cannot connect
to Restbase.) del servidor
/mathoid/local/v1/:): {\displaystyle
N_1=N_2=N} ): 100.000 euros
Tipo fijo: 4%
Periodicidad de pago del tipo fijo: semestral
(base 30/360). Primer pago el 20 de enero de 2009 y
ltimo pago el 20 de julio de 2011.
Tipo variable: Euribor 6 meses.
Periodicidad de fijacin del tipo variable: semestral
con primera fijacin en fecha 20 de julio de 2008 y
ltima fijacin el 20 de enero de 2011.
Periodicidad de pago del tipo variable: semestral
(base 30/360) pagos por periodos vencidos. Fecha
del primer pago 20 de enero de 2009 y ltimo pago
20 de julio de 2011.
Esto significa que la parte A pagar cada 20 de julio y
20 de enero de 2000 euros a la parte B y que recibir
de la parte B cada 20 de julio y 20 de enero el tipo
euribor 6 meses antes sobre el nocional y dividido por
dos ya que el plazo es semestral (el 20 de enero se
paga el tipo a 6 meses que se fij el 20 de julio
anterior ya que se paga el tipo de inters por
vencido).
Valoracin de un swap a tipo fijo/variable.
Descomposicin[editar]
Para valorar un swap a tipo fijo/variable
descompondremos el swap en sus distintos flujos.
Estos son los compromisos de pago/cobro de flujos a
tipo fijo y los compromisos cobro/pago a tipo variable.
Valoracin de los compromisos a tipo
Fijo[editar]
Vamos a empezar con la valoracin de un
compromiso a tipo fijo. Si nos fijamos en el
ejemplo cada uno de los compromisos a tipo fijo
 suponen el pago de una cantidad cierta de
dinero. Descompondremos la cadena de pagos
fijos y obtendremos el valor econmico de cada
uno de ellos. De esta forma, cuando sepamos
valorar un nico compromiso "simple", seremos
capaces de valorar su conjunto.
Cual es el valor econmico del primer pago de
2.000 euros que hay que realizar el 20 de enero
de 2009?
Para realizar la valoracin usaremos el arbitraje.
Esto supone que el valor del compromiso ha de
ser tal que suponga que no podemos ganar o
perder dinero comprando o vendiendo el
compromiso y simultneamente realizar una
operacin financiera que nos permita ganar un
beneficio sin riesgo. Vamos a poner un ejemplo.
Supongamos que estamos en fecha 20 de julio
de 2008 y queremos saber el NPV del
compromiso de pago de 2.000 euros el 20 de
enero de 2009. Si tenemos que pagar 2.000 el 20
de enero de 2009 la cantidad que necesitamos
tener hoy para poder hacer frente a ese pago,
suponiendo que el tipo de inters a 6 meses es el
3,5%, es:
Error al representar (MathML con SVG o PNG
como alternativa (recomendado para
navegadores modernos y herramientas de
accesibilidad): respuesta no vlida (Math
extension cannot connect to Restbase.) del
servidor /mathoid/local/v1/:): {\displaystyle
NPV={2 000 \over (1+{3,5% \over 2})}=1965,6}
Por qu 1965,6? Si invertimos esta cantidad durante
6 meses, a un inters del 3,5% anual, los intereses
que obtendramos al cabo de los 6 meses son 34,4
euros, que sumados a los 1965,6 hacen un total de
2.000 euros que es exactamente nuestro
compromiso. Por tanto el valor econmico de un pago
de 2.000 euros el 20 de enero de 2009 a fecha 20 de
julio del 2.008 es de 1965,6. Esta es la cantidad que
deberemos aceptar para entrar en el compromiso de
pago de los 2.000 euros para que no suponga
ninguna perdida ni beneficio para nosotros.
El arbitraje supone que cualquier otro valor del
compromiso permite hacer un beneficio sin riesgo.
Imaginemos que por entrar en el compromiso de
pagar los 2.000 euros alguien nos paga 1980 euros.
Inmediatamente podemos ver que para atender
nuestro compromiso solo necesitamos 1965,6 euros
con lo que realizamos un beneficio directo de 14,4.
En este caso siempre ser interesante entrar en el
compromiso.
Si alguien estuviera dispuesto a pagar 1950
euros para recibir 2000 euros 6 meses
despus, si los tipos de inters fueran el
3,5%, no nos interesara entrar en el
compromiso de pago sino al revs. Si alguien
est dispuesto a recibir 1950 euros para
pagar 2.000 euros 6 meses despus, lo que
nosotros haremos es la operacin contraria,
si podemos, y pagar los 1950 euros. El nico
problema es que debemos pagar 1950 euros
hoy para recibir 2.000 euros en 6 meses pero
hoy no tenemos los 1950 euros. Muy fcil.
Pedimos un prstamo de 1950 euros a 6
meses al 3,5%. Al cabo de 6 meses
deberemos devolver el prstamo pagando los
intereses (34,13), lo que supone que
devolvemos de nuestro prstamo un total de
1984,13. Cmo devolvemos el prstamo?
con los 2.000 euros que nos paga nuestra
contrapartida. Esto supone que obtenemos
un beneficio en fecha 20 de enero de 2009
de 15,9 euros.
Por tanto esto supone que, por arbitraje, el
valor econmico del compromiso solo pueden
ser los 1965,6, ya que cualquier otro valor
supone que se puede arbitrar y obtener un
beneficio sin riesgo.
Para poder avanzar ms adelante vamos a
empezar a poner estos conceptos en forma
matemtica y empezaremos a dar forma a
nuestra funcin Error al representar
(MathML con SVG o PNG como
alternativa (recomendado para
navegadores modernos y
herramientas de accesibilidad):
respuesta no vlida (Math extension
cannot connect to Restbase.) del
servidor /mathoid/local/v1/:):
\varphi .
Llamaremos factor de descuento a la
funcin que relaciona por arbitraje el valor
econmico de un compromiso futuro de pago
fijo. En nuestro caso Error al representar
(MathML con SVG o PNG como
alternativa (recomendado para
navegadores modernos y
herramientas de accesibilidad):
 respuesta no vlida (Math extension
cannot connect to Restbase.) del
servidor /mathoid/local/v1/:):
{\displaystyle FD_{20/1/2009} =
0,982800983} y por tanto se cumple la
relacin:
Con lo que determinamos la forma de la
funcin Error al representar
(MathML con SVG o PNG como
alternativa (recomendado para
navegadores modernos y
herramientas de accesibilidad):
respuesta no vlida (Math
extension cannot connect to
Restbase.) del servidor
/mathoid/local/v1/:): \varphi para
obtener el valor econmico hoy de un
nico pago cierto a una fecha futura.
Para la agregacin de todos los flujos
futuros a tipo fijo la expresin genrica
ser:
Que en nuestro ejemplo concreto quedara
como:
Podemos ampliar la frmula desarrollando el
trmino , que es el flujo en el momento t,
incorporando todas las variables que
describen el swap obteniendo una frmula
genrica:
Donde N es el nominal sobre el que se aplica
el tipo fijo (C) y p=1,2,...,12 para indicar el
nmero de pagos que se realizan durante un
ao(p=1 anual, p=2, semestral, p=4 trimestral,
etc). En nuestro ejemplo N=100.000, C=4% y
p=2.
Ahora ya hemos hallado el valor econmico de la
pata fija del swap. Nos queda hallar el valor
econmico de la pata flotante para encontrar el valor
de todo el swap en su conjunto. (Para ms
informacin vase tambin VAN)
Convencin para el Factor de descuento[editar
Hemos de parar aqu un momento para tomar una
convencin que luego simplificar mucho la carga
matemtica. Los factores de descuento se calcularn
con los tipos de inters de la curva cupn cero y con
tipo compuesto anual en lugar de tipo de inters
simple. (para ms detalles verfactor de descuento ).
Esta convencin supone que la funcin coge la
siguiente forma:
Error al representar (MathML con SVG o PNG
como alternativa (recomendado para
navegadores modernos y herramientas de
accesibilidad): respuesta no vlida (Math
extension cannot connect to Restbase.) del
servidor /mathoid/local/v1/:): {\displaystyle
FD_t=(1+i_t)^{-t}}
Donde Error al representar (MathML con SVG
o PNG como alternativa (recomendado para
navegadores modernos y herramientas de
accesibilidad): respuesta no vlida (Math
extension cannot connect to Restbase.)
del servidor /mathoid/local/v1/:):
{\displaystyle i_t} es el tipo de inters cupn cero
que hay en el mercado financiero para un periodo que
va desde hoy hasta el momento t (expresado en
aos).
En nuestro ejemplo, el tipo cupn cero equivalente al
3,5% a 6 meses (llamado tambin tipo nominal) ser
el que satisface la ecuacin . Siendo Error al
representar (MathML con SVG o PNG como
alternativa (recomendado para navegadores
modernos y herramientas de accesibilidad):
respuesta no vlida (Math extension
cannot connect to Restbase.) del servidor
/mathoid/local/v1/:): {\displaystyle
i_t=3,5%}
Valoracin de los compromisos a tipo
Variable[editar]
Bien, aqu nos aparece un problema. Si hoy es el 20
de julio de 2008, el compromiso a tipo variable del
primer periodo, el que en nuestro ejemplo tenemos
que pagar en fecha 20 de enero de 2009, es
conocido, ya que es el tipo euribor a 6 meses en
fecha de hoy. Pero, cmo valoramos el compromiso
de pagar el eurbor a 6 meses que habr el 20 de
enero de 2009, pagadero el 20 de julio de 2009, si
desconocemos ahora cul ser? Tampoco sabemos
cules sern los sucesivos tipos euribor a 6 meses
que se fijarn durante la vida del contrato. cmo nos Estos intereses son el valor econmico a la fecha de
lo hacemos entonces para encontrar el valor vencimiento que tiene el compromiso de poder pagar
econmico (NPV) de los compromisos de la pata los eurbores futuros. Para hallar el valor econmico
variable? De nuevo un anlisis por arbitraje nos hoy solo debemos aplicar la frmula que hemos
permitir hallar la solucin y encontrar la frmula que usado para hallar el valor actual de un compromiso
necesitamos. nico a tipo fijo, es decir, le aplicaremos el factor de
descuento a los intereses I. Un poco de lgebra nos
Supongamos que el compromiso de la pata variable lleva a encontrar el valor econmico del compromiso
es de pago del mismo. As, en nuestro ejemplo, si flotante (NPV):
somos la contrapartida B deberemos hacer las
operaciones financieras necesarias para poder pagar Aunque
el euribor 6 meses de cada periodo, pero que ahora pareca
desconocemos cual es el tipo que se fijar. La nica complejo
forma de conseguir que podremos pagar el tipo acabamos
flotante sobre el nocional durante toda la vida del de obtener
contrato es teniendo en nuestras manos una cantidad el valor
igual al nocional e invirtindola cada 6 meses al tipo econmico
euribor 6 meses. Los intereses que recibiremos de de los
nuestro capital invertido son los que nos permitirn compromiso
pagar el compromiso a tipo flotante de nuestro s de la pata
contrato de swap. Pero, de nuevo, nos aparece otro flotante del
problema: no tenemos en nuestras manos el capital. swap.
Por tanto deberemos pedir a prstamo este capital a
fecha de hoy y lo devolveremos a la fecha de El arbitraje
vencimiento del mismo. Es decir la capacidad de nos
poder pagar los diferentes euribores futuros tiene garantiza
un coste econmico (VE=VA=NPV) igual al coste nuevamente
de pedir prestado el nocional durante la vida del que el valor
contrato. No importa cuales vayan a ser los tipos debe
euribor 6 meses futuros que hoy seremos capaces de ser Error al
pagarlos si hemos pedido a prstamo el nocional del represent
contrato de swap y lo devolvemos a la fecha de
ar
vencimiento.
(MathML
Entonces el valor econmico del compromiso de la con SVG
pata flotante vendr dado por el valor hoy de los o PNG
intereses que hemos de pagar al vencimiento del como
contrato del nocional pedido a prstamo. alternativa
(recomen
Necesitamos ahora un poco de matemticas para dado para
poner estos conceptos en orden. Si pedimos hoy un
navegado
prstamo de capital N y lo hemos de devolver en el
momento v, el capital a devolver es: res
modernos
y, por tanto los intereses I que debemos pagar y
a la fecha de vencimiento son: herramien
Error al representar (MathML con SVG o tas de
PNG como alternativa (recomendado accesibili
para navegadores modernos y dad):
herramientas de accesibilidad): respuesta
respuesta no vlida (Math extension no vlida
cannot connect to Restbase.) del
(Math
servidor /mathoid/local/v1/:):
extension
{\displaystyle I=N_v-N}
cannot
connect ejemplo, que
to paga fijo y
Restbase. recibe
variable, el
) del NPV del
servidor swap ser el
/mathoid/ NPV de la
local/v1/: pata de
): cobro (en
{\displayst este caso
yle N variable)
menos el
\cdot(1- NPV de la
FD_v)} ya pata de
que como pago (en
hemos este caso
mostrado en fijo). Por
las tanto:
secciones
anteriores
Error al
cualquier
otro valor represent
hara posible ar
un beneficio (MathML
sin riesgo. con SVG
o PNG
Valoracin como
de un swap alternativa
a tipo
fijo/variable.
(recomen
Valor total dado para
del navegado
swap[editar res
] modernos
y
El Valor herramien
econmico tas de
de un swap
accesibili
en su
totalidad dad):
vendr dado respuesta
entonces no vlida
por la (Math
agregacin extension
de valores cannot
de los
connect
compromiso
s de las dos to
partes. Restbase.
Entonces si ) del
suponemos servidor
que somos /mathoid/
la local/v1/:
contraparte
):
A de nuestro
{\displayst
yle \left ( (1-
NPV=N \ \ FD_v)-\su
cdot (1- m_{t=0}^V
FD_v)-\su FD_t {C
m_{t=0}^V \over p}
FD_t \cdot \right )}
\left (N
{C \over
p} \right )} Igual que
comentba
mos para un
o,
compromiso
reordenando
nico de tipo
;
fijo el NPV
puede ser
positivo,
Error al negativo o
represent cero. La
ar operacin es
(MathML justa para
con SVG ambas
o PNG partes si el
NPV=0 y si
como
tiene un
alternativa valor
(recomen positivo para
dado para nosotros
navegado deberemos
res pagar a la
modernos contrapartid
a dicho
y
importe para
herramien que sea
tas de aceptable
accesibili para ella
dad): entrar en el
respuesta contrato de
no vlida swap. En
caso que el
(Math
NPV sea
extension negativo
cannot nuestra
connect contrapartid
to a nos
Restbase. deber
) del compensar.
servidor
/mathoid/
local/v1/:
):
{\displayst
yle
NPV=N
Relaciones momento de
que su
podemos contratacin.
establecer a
partir del Esta
NPV de un relacin la
swap[editar podemos
] formular
como:
La frmula
que hemos Error al representar (MathML con SVG o
obtenido PNG como alternativa (recomendado
determina para navegadores modernos y
que los herramientas de accesibilidad):
valores de respuesta no vlida (Math extension
los cannot connect to Restbase.) del
parmetros servidor /mathoid/local/v1/:):
de un swap {\displaystyle C=p \left ( {1-
(el NPV, C, FD_v\over\sum_{t=0}^v FD_t} \right )}
p, etc) han
de mantener
Esta es la forma como se cotiza un swap fijo variable
la relacin
en los mercados financieros: en funcin deltipo fijo al
formulada.
vencimiento del contrato siendo estndares el resto
Algebraicam
de parmetros (por ejemplo, la periodicidad del cupn
ente
fijo, el ndice variable, etc). La parte estndar de un
podemos
swap en los mercados financieros actualmente es:
despejar
cualquiera
de las ndi
variables de cev
aria
la ecuacin
ble:
para hallar
Euri
su valor, que bor
debe ser 6
nico, para mes
evitar una es,
condicin de liqui
arbitraje. daci
n
La relacin sem
ms comn estr
en los al. B
mercados ase
financieros ACT
/360
es la que
refleja el
valor del tipo ndi
fijo que hay ce
Fijo:
que
Seg
establecer
n
para que el el
NPV del mo
swap sea men
igual a cero to
en el de
 mer tiempo,
cad suponie
o, ndo una
liqui evoluci
daci n de los
n tipos de
anu inters
al. B
segn
ase
se
30/3
60 indica
en la
misma.
Con
Supone
dicio
nes mos que
lega somos
les: la
ISD contrapa
Ao rtida que
CM paga el
OF tipo fijo.
Es
Los dems swaps expuestos en este artculo interesa
necesitan otra formulacin matemtica para calcular nte
su NPV. observar
los
Ejemplo siguient
de es
valoraci puntos:
n de
un swap El
en el tipo
tiempo. de
Resulta mer
dos, cad
valoraci o en
n y el
liquidaci mo
men
ones del
to
swap[e
de
ditar] cont
ratar
En la el
tabla swa
siguient p es
e se el
reflejan 3.96
los %
valores mie
de la ntra
s
operaci
que
n de
nos
swap otro
del s
ejemplo ace
en el pta
mos aci
entr n
ar
en Hay
un mo
swa men
p tos
pag en
and la
o un vida
4% de
que la
es oper
may aci
or, n en
por que
lo tene
que mos
la ben
cont efici
rapa o ya
rtida que,
nos por
ha eje
de mpl
com o, a
pen fech
sar a
por 20/1
ello /201
y 0
nos hem
pag os
a pag
una ado
prim 140
a euro
inici s
al por
de las
110 liqui
euro daci
s, el one
NPV s
, hast
para a la
que fech
sea a,
neut pero
ro el
para NPV
nos del
otro swa
s p es
entr de
ar 1.13
en 2
la euro
oper s.
Esto inter
sup s
one son
que sup
si erior
can es
cela al
mos 4%
la que
oper hem
aci os
n en de
esa pag
fech ar.
a,
nos Al
pag final
ara de
n la
los oper
1.13 aci
2 n,
euro aun
s y, que
por ha
tant habi
o, do
habr mo
am men
os tos
reali en
zad que
o un ten
ben amo
efici s un
o de ben
992 efici
euro o, la
s mis
por ma
la nos
oper ha
aci resu
n. El ltad
NPV o
es perd
posi edor
tivo a ya
porq que
ue hem
en os
aqu aca
el bad
mo o
men pag
to and
los o
tipo 515
s de euro
 s en rtidas.
total Los
. contrato
s de
swap
realizad
os entre
entidade
s
financier
as estn
estandar
izados
bajo
contrato
s
marcos I
SDA.
Existe
para
entidade
s
espaol
as una
versin
estandar
izada
sujeta a
la
legislaci
n
espaol
a, es el
contrato
CMOF,
redactad
o en
castella
no.

Negoci
acin
de un
swap[e
ditar]

Los
swaps
se
negocia
n OTC e
ntre dos
contrapa
Conce En un
pto swap, el
concept
de coti o
zacin de cober
o tura se
Pricin le suele
g aplicar
desde
y cober
dos
tura o mbitos:
Hedg
e de Pen
un san
swap[e do
en
ditar] que
el
Por coti swa
zacin p es
de un un
swap instr
entende ume
remos el nto
acto de de
calcular cob
y ofrecer ertur
a de
un
otro
precio
s
para instr
contrata ume
r un ntos
swap. fina
En los ncie
mercado ros.
s
financier Pen
os las san
contrapa do
rtidas en
que se com
dedican o
perman cubr
entemen ir el
te a ries
cotizar go
swaps de
tipo
se
de
llaman c
inter
readore s
s de que
mercad nos
o o "ma prov
rket oca
makers entr
". ar
 en ries
un go
swa de
p. crd
Este ito
ries exist
go e
se por
suel la
e posi
cubr bilid
ir ad
con de
otro que
s nue
instr stra
ume cont
ntos rapa
fina rtida
ncie no
ros pag
(futu ue
ros, sus
dep com
sit pro
os, mis
etc) os.
o En
con este
otro cas
s o, el
swa ries
ps. go
de
Otras
crd
consid ito
eracion no
es es
del
sobre nom
un inal,
swap[e sino
ditar] del
NPV
del
Los swa
swa p en
ps cad
est a
n mo
suje men
tos to
a que
ries quer
go emo
de s
crd med
ito. ir el
El mis
 mo. era
Exis cont
ten rapa
mec rtes
anis disp
mos uest
, as a
com entr
o ar
las en
gara la
nta oper
s en aci
form n de
a de swa
cola p
teral que
, quer
para emo
miti s lo
gar que
el impli
ries ca
go que
de tene
crd mos
ito. un
ries
Los go
swa de
ps liqui
est dez.
n En
suje este
tos cas
al o
ries podr
go a
de ser
liqui posi
dez. ble
En no
dete enc
rmin ontr
ada ar a
s nadi
situ e
acio para
nes pod
de er
mer reali
cad zar
o la
podr oper
a aci
ser n de
que cob
no ertur
hubi ao
esp n
ecul falla
aci n.
n Es
que muy
des imp
eam orta
os. nte
Es tene
perti rlo
nent en
e cue
men nta
cion para
ar su c
que ober
el tura
swa oh
p edg
man e y
tien cotiz
e un aci
may n.
or
Otros
ries
go a swaps
com de tipo
para de
cin
de
inters
otro [editar]
s
instr En
ume general
ntos cualquie
fina r
ncie combina
ros cin de
deri compro
vad
misos
os.
de
Si la
liqui cobro/pa
dez go de
del flujos de
mer tipo de
cad inters
o constitu
des ye un
apar swap.
ece Las
ento combina
nce ciones
s los son
mod pues
elos
muy
de
numeros
valo
raci as (por
ejemplo pata
tipos para
fijos que
crecient tenga
es en el algn
tiempo, inters
nominal el swap.
es
variable Asset
s en el Swap[e
tiempo, ditar]
etc). A
continua Los
cin se pagos/c
expone obros de
una una pata
relacin replican
de los los
ms cobros/p
usuales agos de
en los un
mercado activo
s mientras
financier que la
os. otra
pata se
Swap paga a
Fijo vs un tipo
Fijo o de
Variable inters
vs variable.
Variable Sirve
[editar] para
convertir
Los los flujos
pagos y de un
cobros activo
estn que
referenci tengamo
ados a s (por
ndices ejemplo
fijos o un bono
variable que
s en las paga un
dos tipo fijo)
partes. a otros
Los que nos
ndices convien
deben en ms.
ser para
diferente
s
periodici
dades
en cada
Call de swap
Money en el
Swap[e que una
ditar] de las
patas
Tipo est
especial referenci
de swap ado a un
muy tipo
utilizado variable
en el a corto
mercado plazoEu
interban ribor (inf
cario. erior a
Suelen 12
tener meses)
vencimi y la otra
entos est
desde referenci
un mes ada a un
a un tipo
ao. superior
Una de a 12
las meses
patas es (por
a tipo ejemplo,
fijo el tipo
mientras swap a
que la 10
otra esta aos).
indexad Se suele
a a un cotizar
tipo en % del
variable tipo
diario referenci
(normal ado al
mente el ndice
tipo Eoni superior
a). Se a 12
suele meses.
realizar
una sola Swaps
liquidaci de tipo
n a
de
vencimi
ento. inters
en
Constan diferen
t tes
Maturity divisas
Swap[e [editar]
ditar]
Un caso
Tipo especial
especial de todos
los para
swaps incorpor
de tipo ar este
de hecho.
inters
es el
caso en
Eje
el que mpl
una de
las
os
patas de
est
referenci
otro
ada a s
una
divisa y
tipos
el otro a de
otra
divisa.
swa
Por ps[edi
ejemplo tar]
la pata
fija Swap
podra de
estar divisas
expresa [editar]
da en
Artculo
tipos de
principal:
inters
Swap de
en dlar
divisas
es y la
otra
Suelen
en euros
confundi
. (No
rse con
debe
los
confundi
swaps
rse con
de tipos
la
de
operaci
inters,
n de
donde
swap de
cada
divisas)
pata
Las
est
frmulas
referenci
expresa
ada a
das para
una
el swap
divisa
simple
diferente
fijo vs
. La
variable
confusi
son
n puede
diferente
provenir
s en
por la
este
utilizaci
caso
n del
trmino Equity
swap Swap[
ingls,
editar]
que
significa
intercam En un
bio. Equity
swap
una de
Un swap
las
de
patas
divisas e
est
s una
referenci
operaci
ada a
n que
tipo de
incluye
inters y
una
la otra
comprav
referenci
enta de
ada a
divisas a
renta
fecha de
variable
hoy y
(accione
una
s o w:en
operaci
:Equity
n de
Equity)
sentido
. La
contrario
referenci
a fecha
a a la
futura a
renta
un
variable
precio
puede
prefijado
ser de
hoy. Por
muchos
ejemplo,
tipos
una
(variaci
compra
n sobre
de
un
dlares
ndice,
contra
sobre un
euros
portafoli
hoy a un
o de
precio
accione
de 1.40
s,
y venta
rentabili
de euros
dad en
contra
un
dlares
periodo,
dentro
etc)
de un
mes a
un
precio
de
1.3970.
Total muy
Return similar a
lo que
Swap[ es el
editar] forward.

En este
tipo de
swap se 1 Resea histrica
intercam
bia un 2 SWAP
tipo de
inters 3 Caractersticas de las operaciones SWAP
flotante
por 4 Tipos de SWAPS
todos
los flujos 5 Tipos de riesgo
de un
activo 6 Conclusiones y recomendaciones
financier
o por INTRODUCCIN
variados
y Dentro de nuestro marco social, cultural, poltico y econmico
complej se han creado y desarrollado innovaciones para beneficio y
crecimiento del hombre. Gracias a ellas se han aprovechado
os que
oportunidades que permiten la evolucin social y econmica
sean. de nuestro entorno, por eso es importante acoger
Usualm la tecnologa y los nuevos proyectos, como una alternativa de
ente si crecimiento y expansin profesional.
el
vencimi Dentro del desarrollo del presente trabajo, se da a conocer una
ento de de las ms importantes operaciones, que
este las empresas pueden desarrollar para hacer crecer
su capital con mayor rendimiento y efectividad, de tal forma
swap es
que si no tiene liquidez inmediata se puede hacer un canje o
inferior transaccin para as aprovechar oportunidades y hacer crecer
al del su actividad econmica.
activo
financier Esta oportunidad que nos ofrece el mercado para desarrollo y
o suele sostenimiento empresarial, son las operaciones SWAP, la
haber cuales en forma general, representan una reestructuracin del
portafolio de inversiones, a travs de una transaccin de
un
ttulos valores con determinadas caractersticas por otra otras
intercam que puede afectar en forma positiva los portafolios
bio, de inversin.
entre las
partes,
RESEA HISTRICA
del
activo al
Aunque esta operacin vino a existir slo en aos muy
inicio y recientes, puede ser relacionado a los aos 1800s y la Ley de
vencimi Ventaja Comparativa de Ricardo. En esencia, esta ley
ento del examinaba dos pases los cuales ambos producan tela y vino.
contrato
de swap Si el pas A puede producir tela ms eficientemente que el pas
a un B, entonces tiene una ventaja absoluta en tela sobre el pas B.
precio Sin embargo, de acuerdo a la Ley de Ricardo, an si A tiene
una ventaja absoluta en tela y vino sobre B, no hay razn para
prefijado
que los dos no puedan negociar.
.Es un
contrato
El pas A debe concentrarse en producir el producto en el cual
tenga la ms grande ventaja comparativa, dejando
la produccin del otro producto para B. Los dos pueden
entonces intercambiar sus abastecimientos en exceso uno con
otro, permitiendo a ambos completar sus requerimientos para
el producto que no producen- con el resultado neto de que
ambos se beneficiaran.
Swap
1. Conceptos
Un swap, o permuta financiera, es un contrato por el cual dos
partes se comprometen a intercambiar una serie de cantidades
de dinero en fechas futuras. Normalmente los intercambios de
dinero futuros estn referenciados a tipos de inters,
llamndose IRS (Interest Rate Swap) aunque de forma mas
genrica se puede considerar un swap cualquier intercambio
futuro de bienes o servicios (entre ellos el dinero) referenciado
a cualquier variable observable. Un swap se considera un
instrumento derivado.
Partes de un swap
Dado que es un compromiso de intercambio de dinero a futuro
un swap tiene dos partes para cada uno de los contratantes: el
compromiso de cobro de dinero a futuro y el compromiso de
pago de dinero a futuro. Cada una de estas dos partes se les
suele llamar "pata" proveniente del termino ingls "leg" (pata o
pierna).
Representacin grfica de un swap
Para una de las partes un swap grficamente se puede
representar como:
Donde se producen para una de las contrapartidas una serie
de flujos de cobros y una serie de flujos de pagos desde el
momento inicial del contrato (t=0) hasta su vencimiento (t=v).
Lgicamente, lo que para una de las partes son compromisos
de cobros son compromisos de pagos para la otra y viceversa.
Valor de un swap
Como cualquier contrato o compromiso de flujos de dinero un
swap debe tener un valor econmico. El valor econmico del
swap, si es determinable, reflejar en cualquier momento
del tiempo la cantidad a pagar o recibir para entrar o salir del
contrato en funcin de en que lado del compromiso estamos.
Utilidad de un swap
Bsicamente podemos hablar de dos utilidades o motivos por
el que tendremos inters en entrar en un swap:
a) Cambiar nuestros bienes
o recursos futuros: Puede interesarnos para nuestro negocio
intercambiar durante un tiempo bienes o recursos que
generaremos por otros bienes o recursos necesarios para
nuestra actividad o bienestar.
b) Especulacin: Al igual que la especulacin en otros activos,
entraremos en un swap si nuestra visin es que los bienes que
recibiremos a futuro van a suponer para nosotros mayor valor
que los bienes que entregaremos a futuro.
CUL ES SU FINALIDA
Mitigar las oscilaciones de las monedas Y de los tipos
de inters
Reducir el riesgo del crdito
Reestructuracin de portafolios, en donde se logra
aportar un valor agregado para el usuario
Disminuir los riesgos de liquidez
EN QU SE FUNDAMENTAN?
En la ventaja comparativa que disfrutan algunos participantes
en ciertos mercados, que les permite acceder a
determinadas divisas u obtener tasas de inters en
condiciones mas ventajosas.
QUIN LAS EXPIDE?
Corredores miembros de las cmaras de
compensacin de las bolsas de futuros y opciones del exterior.
Intermediarios del mercado cambiario.
Entidades financieras del exterior calificadas como de
primera categora segn reglamentacin de carcter general
que adopte el Banco de la Repblica.
CMO SE REALIZAN LAS TRANSACCIONES?
Por telfono o internet y se cierra el trato cuando se
llega a un acuerdo sobre la tasa de cupn, la base para la tasa
flotante, la base de das, fecha de inicio, fecha de vencimiento,
fechas de rotacin, ley aplicable y documentacin.
La transaccin se confirma inmediatamente
mediante fax seguido de una confirmacin escrita.
2. CARACTERSTICAS DE A Swaps de tipos de inters: Este tipo de Swap es el
ms comn y busca generarle mayor liquidez,
LAS OPERACIONES SWAP especialmente a una de las partes involucradas en la
operacin, y a las otras ganancias sobre las
A TIPOS DE RIESGO
adquisiciones aunque a un plazo mayor, en este se
juega con los intereses pero las partes tienen en
B PARTICIPANTES cuenta tambin los valores y los plazos, por lo general
se intercambian intereses de tipo fijo a variable o
A TIPOS DE RIESGO: Por ser el SWAP un mecanismo de viceversa, involucrando entonces un riesgo como lo
cobertura que permite cubrir los riesgos de mercado, tiene cualquier operacin financiera.
solvencia y liquidez, en la realizacin de cualquier
operacin SWAP se deber indicar la clase de riesgo que B Swap de divisas: Es un contrato financiero entre dos
esta cubriendo el originador del SWAP, teniendo en cuenta partes que desean intercambiar su moneda principal
lo siguientes: en diferentes monedas, por un periodo
Riesgo de Mercado: Se entiende como riesgo de de tiempo acordado. Durante el perodo de tiempo del
mercado la contingencia de prdida o ganancia por la acuerdo, las partes pagan sus intereses recprocos.
variacin del valor de mercado, frente al registrado en la Lo anterior:
valoracin del portafolio del inversionista, producto de Rompe las barreras de entrada en los mercados
cambios en las condiciones del mercado, incluidas las internacionales.
variaciones de tasas de inters o tasas de cambio. El coste del servicio resulta menor que sin la
operacin Swap.
Riesgo de Solvencia: Se entiende como riesgo de Tiene forma contractual, que obliga al pago de los
solvencia la contingencia de perdida por el deterioro de intereses recprocos.
la estructura financiera del emisor o garante de un ttulo Se suele realizar a travs de intermediarios.
valor, que pueda generar disminucin en el valor de
la inversin o en la capacidad de pago, total o parcial, de
C Swaps sobre materias primas:
los rendimientos o del capital de la inversin.
A travs de este tipo de Swap muchas empresas en
especial del sector manufacturero han podido generar
Riesgo de Liquidez: Este riesgo considera la necesidad
mayor liquidez para sus organizaciones, en este tipo
del tenedor del titulo valor de hacer lquido un titulo de
de transacciones la primera contraparte realiza un
largo plazo, originando una posible perdida o ganancia.
pago a precio unitario fijo, por cierta cantidad de
alguna materia prima, luego la segunda contra parte
A PARTICIPANTES: En todo SWAP deben participar como le paga a la primera un precio variable por una
mnimo tres tipos de agentes. cantidad determinada de materia prima, las materias
Originador: Es quien necesita cubrir un riesgo especifico primas involucradas en la operacin pueden ser
y utiliza la figura de sustitucin de ttulos -SWAP-. Deber iguales o diferentes.
tomar una posicin de vendedor inicial de un primer titulo Para las empresas es mucho ms favorable realizar
valor originador del riesgo y de comprador final de un estas transacciones pues de esta manera evitan el
segundo titulo valor que cumpla con las caractersticas riesgo de crdito, asumiendo solo riesgos de mercado
para cubrir el riesgo de portafolio que dio origen a la especialmente de la parte que realiza los
operacin. Estos tramos de las operaciones SWAP no se pagos variables, la ventaja es que esta ultima puede
sujetarn a precios de mercado, sin embargo, es entrar a negociar precios, calidad etc., de las materias
necesario que las sociedades comisionistas de bolsa primas, teniendo en cuenta que es la parte que asume
obtengan comunicacin escrita por parte de mayores riesgos.
ste cliente en la que clara y expresamente manifieste que
conoce las condiciones de mercado actuales y est
4 TIPOS DE SWAPS
dispuesto a realizar dichas operaciones.
Agente Volteador: Es el encargado de dar vuelta a los
ttulos valores del originador, actuando como
intermediario. Su posicin deber ser neutral y
su utilidad estar dada bsicamente por la diferencia en
los precios, y sta no podr ser en ningn caso negativa ni
podr subsanarse con utilidades de otras operaciones
independientes al SWAP en cuestin. El volteador solo
podr comprar los ttulos en posicin definitiva cuando sea
previamente autorizado por el originador mediante
autorizacin escrita.
Tercero: Puede ser uno o varios los terceros que
intervengan en esta categora. Es quien vende el (los)
titulo (s) que sustituir el titulo originador del SWAP y
quien compra el titulo que dio origen a la operacin SWAP.
Cuando se presenten dos terceros independientes, estas
operaciones se realizarn con el agente volteador y se
regirn por precios reales del mercado.

3
 Ejemplo: un Swap a tres aos sobre petrleo; esta transaccin
es un intercambio de dinero basado en el precio
del petrleo (A no entrega a B petrleo en ningn momento),
por lo tanto el Swap se encarga de compensar cualquier
diferencia existente entre el precio variable de mercado y el
precio fijo establecido mediante el Swap. Es decir, si el precio
del petrleo baja por debajo del precio establecido, B paga a A
la diferencia, y si sube, A paga a B la diferencia.
Swaps de ndices burstiles: El mercado de los Swaps sobre
ndices burstiles permite intercambiar el rendimiento del
mercado de dinero por el rendimiento de un mercado burstil,
este rendimiento se refiere a la suma de dividendos recibidos,
ganancias y/o prdidas de capital.
TASAS DE INTERES SWAPS
Tipos:
Cupon Swap: Se intercambian tasas fijas por tasas variables
o viceversa.
Basis Swap: Se intercambian tasas variables por tasas
variables.
Cross Currency Rate Swap: Se intercambian tasas fijas en
una divisa por tasas variables en otras.
Otros tipos de swaps
Equity Swap : En un Equity swap una de las tasas
esta referenciada a tipo de inters y la otra referenciada a
renta variable (acciones o "Equity"). La referencia a la renta
variable puede ser de muchos tipos (variacin sobre un ndice,
sobre una cesta de acciones, rentabilidad en un periodo, etc)
Total Return Swap: En este tipo de swap se
intercambia un tipo de inters flotante por todos los flujos de
un activo financiero por variados y complejos que sean.
Usualmente si el vencimiento de este swap es inferior al del
activo financiero suele haber un intercambio, entre las partes,
del activo al inicio y vencimiento del contrato de swap a un
precio prefijado.
Tipos o variables de Swaps de inters:
Swaps amortizables y acumulables: Los swaps
amortizables son swaps cuyo principal est reducido o
concentrado en uno o ms puntos en el tiempo, previos al
vencimiento del swap. Los swaps acumulables son aquellos en
los que el principal es incrementado en uno o ms puntos del
tiempo previo al vencimiento del mismo. Ambos tipos de swaps
requieren un calendario separado estipulando
la amortizacin o acumulacin de todas principales.
Swaps roller coaster: tipo "montaa rusa", estos
swaps estipulan un periodo de acumulacin seguido de un
periodo de amortizacin de principales.
Swaps indexados a hipoteca y de obligacin
hipotecaria colateral: Clase especial de swap que estipula la
amortizacin de los principales de una manera consistente con
la amortizacin de una hipoteca.
Swaps base: tambin llamados de variables-por
-variable (flotante-por-flotante), son swaps en los que ambas
ramas son variables, pero estn vinculados a dos diferentes
ndices. Por ejemplo, un lado puede estar vinculado a la tasa
LIBOR, mientras que la otra lo est a 3 meses LIBOR.
Swaps de curva de rendimiento: estos son swaps
en los que ambas ramas son flotantes, pero a diferencia de los
swaps base, los lados flotantes pueden estar vinculada a la
tasa de largo plazo. Por ejemplo, una rama puede estar
vinculada a la tasa de subasta sobre los bonos del Tesoro a 30
aos, y la otra puede estarlo a la tasa de la subasta relativa a
pagars del Tesoro a 10 aos..
Swaps cupn cero: Estos son swaps de fija-por-
variable en los que la tasa fija es la de un bono cupn cero.
Esto es, no se hace ningn pago en la rama de la tasa fija del
swap hasta el vencimiento. Al trmino de ste, se fija la tasa y
se hace un pago simple.
Swaps forward: tambin llamados swaps diferidos,
son aquellos en los que el cupn se fija en la fecha de la
transaccin, pero el swap no comienza hasta una fecha
posterior. Esto podra ser 60 das, 1 ano despus, etctera.
Swaps de fijacin retrasada de tasa: Tambin
llamados swaps de fijacin diferida de tasa. Estos son swaps
que comienzan inmediatamente, pero su cupn no se fija sino
en una fecha posterior. El tiempo de fijacin de la tasa se deja,
con lmites contractuales, a la discrecin del usuario final.
Cuando se fija la tasa, se hace de acuerdo con una frmula
previamente acordada.
Swaps pagadero a la demanda colocable y
ampliado o swaps con opcin: Estos son swaps en lo que
una parte tiene el derecho, no la obligacin, de extender o
acortar la duracin del mismo. En un swap pagadero a la
demanda, el que paga la tasa fija tiene el derecho a terminar
antes el swap. En el swap colocable, el que paga la tasa
variable tiene el derecho de extender la duracin del swap ms
all de la fecha programada de terminacin.
Swap de tasa lmite: Estas son swaps en los que la
tasa variable tiene lmites. Estos pueden obtenerse mediante
la incorporacin de dichos lmites directamente en los trminos
del swap, o conseguirse por separado o travs de un agente
especfico.
Swaps reversibles: estos son swaps en los que el
que paga la tasa fija y el que paga la tasa flotante invierten sus
papeles una o ms veces durante la vida del mismo. Esto es,
el que paga la tasa variable se convierte en el que paga la tasa
fija, a su vez, el que paga la tasa fija se convierte en el que
paga la tasa variable.
Swaps estacionales: este swap se define en forma
amplia como cualquier swap diseado con el fin de
desestacionalizar los flujos de efectivo de una empresa. Existe
un buen nmero de estructuras que pueden hacer esto. Una
 es con el swap de fija por fija con fechas de pago no
concordantes.
Swaps basados en activos: la mayora de los swaps
se realizan con el fin de transformar el carcter de
la obligaciones de los usuarios finales. En aos recientes,
muchos swaps se han suscrito con el fin de transformar el
carcter de los activos de dichos usuarios. Cobertura contra el
riesgo en la tasa de inters: Muchas empresas estn
expuestas al riesgo de movimientos en la tasa de inters.
Muchas veces el riesgo por naturaleza, es de un periodo.
Cuando el riesgo en la tasa de inters es por un periodo as,
fcilmente puede ser cubierto con futuros sobre tasas de
inters o con u contrato adelantado sobre tasas de inters. En
otro caso el riesgo de la tasa de inters es multiperidico por
naturaleza. En estos casos el riesgo puede ser cubierto con un
despliegue de futuros o un swap. Si la exposicin se extiende
muy lejos en le futuro entonces las alternativas utilizando
futuros normalmente no funcionan, porque los futuros mayores
a un ao son raramente lquidos. Los contratos adelantados
tambin pueden ser no lquidos o simplemente ser no eficaces
en su costo. En cualquier evento, la alternativa del swap es
preferible.
Swaptions: Las llamadas swaptions son opciones
sobre swaps. Esto es, una empresa espera tener necesidad de
un swap en fecha posterior, pero no est segura de que el
swap sea necesario. Al mismo tiempo, encuentra que la
fijacin del precio de los swaps actuales es atractiva y quisiera
cerrar la operacin a ese precio. Por lo tanto, compra una
swaption con un swap a la par, lo que le da el derecho, no la
obligacin, de entrar en este swap durante algn perodo de
tiempo.
TIPOS DE RIESGO
Riesgo diferencial: Este ocurre cuando se cubre un Swap
con un bono, y se presenta un cambio en el diferencial del
Swap con respecto al bono lo que ocasiona una prdida o una
utilidad en la rentabilidad del Swap.
Riesgo de base: Este tipo de riesgo y es muy comn debido
a que mu7chas de las empresas que realizan estas
operaciones no preveen correctamente la diferencia que se
puede dar entre las tasas de referencia y las tasas implcitas
en el contrato a futuro, lo que al final origina una perdida para
una de las partes
Riesgo de crdito: Es tipo de riesgo como ya se menciono
se refiere a que la contraparte no cumpla con sus
obligaciones. Este riesgo siempre tiende a incrementarse
cuando las obligaciones de inters son intercambiadas en
diferentes monedas.
Riesgo de reinversin: Es derivado del riesgo de crdito,
cuando hay cambios en las fachas de pago, es necesario
reinvertir en cada fecha de rotacin.
Riesgo de tipo de cambio o cambiario: Este tipo de riesgo
se presenta con frecuencia, especialmente en los Swap de
divisas, al tener que pagar ms de la propia moneda o de
cualquier otra para adquirir la misma cantidad de divisa que se
acord en el contrato, lo cul al final afecta el costo de la
transaccin.
CONCLUSIONES Y RECOMENDACIONES
Durante los ltimos aos el mercado de swaps ha crecido
considerablemente, debido principalmente a la
creciente globalizacin de los mercados, en los que la
diversidad en estructuras e instituciones hacan necesario el
uso de un instrumento que unificara las ventajas y desventajas
de aquellos. Adems, lapromocin y el uso que le dieron
los bancos centrales, principalmente el Banco Mundial, ayud
a implementarlo de forma relativamente rpida entre las
diferentes figuras participantes en los mercados financieros.
Gracias al aporte del mercado, en permitir realizar estas
operaciones, muchas empresas han logrado una ventaja
competitiva que permite una reestructuracin efectiva en sus
portafolios y mejorar su capacitad econmica en forma
exponencial y duradera.
Por tal razn los swap son un instrumento financiero
utilizado con el objeto de reducir
los costos de financiamiento, as como sus riesgos, lo
cual genera mayor liquidez y solidez en sus activos.
Gracias a estas operaciones se disminuyen los cambios en las
divisas o tasas de inters a los que estn expuestos, pues una
transaccin de esta magnitud, logra fijar una tasa para la
moneda de tal forma que no sufra las mal trasformaciones del
mercado y su constante deterioro.
Las operaciones no solo permiten que dos o ms partes
intercambien las ventajas que pueden obtener en sus
respectivos mercados. Sino que tambin tienen como finalidad
la reestructuracin directa o indirecta de sus deudas, y,
adems, reducir el costo financiero de todas las partes.
En la actualidad existen dos tipos de operaciones swap que
representan ms del 90% de las operaciones realizadas en el
mundo: de tasas de inters y de divisas, las cuales son las
ms usadas por su nivel de utilidad y beneficio.
As como las operaciones ofrecen grandes oportunidades para
los empresarios, tambin se pueden general grandes
complicaciones si no se conocen con claridad las reglas de
estas, pues bajo esta modalidad sola las pueden expedir
entidades autorizadas, como en el caso de nuestro pas el
Banco de la Republica, quien es el que da la facultad para que
ciertas entidades bancarias realicen este tipo de
transacciones.
Con lo anterior se recomienda que las empresas que se
encuentra facultadas para ser este tipo de operaciones,
conozcan las debilidades y beneficios de las operaciones, ya
que en muchas ocasiones por desconocimiento se pueden
oportunidades que pueden afectar el portafolio de servicios.

An Introduction To Swaps
Derivatives
contracts can be divided into two general
families:
1. Contingent claims, e.g. options
2. Forward claims, which include exchange-
traded futures, forward contracts and swaps
SEE: Options Basics
A swap is an agreement between two parties to
exchange sequences of cash flows for a set
period of time. Usually, at the time the contract is
initiated, at least one of these series of cash
flows is determined by a random or uncertain
variable, such as an interest rate,
foreignexchange rate, equity price or commodity
price. Conceptually, one may view a swap as
either a portfolio of forward contracts, or as
a long position in one bond coupled with a short
position in another bond. This article will discuss
the two most common and most basic types of
swaps: the plain vanilla interest rate and currency
swaps.
The Swaps Market
Unlike most
standardized options and futures contracts,
swaps are not exchange-traded instruments.
Instead, swaps are customized contracts that are
traded in the over-the-counter (OTC) market
between private parties. Firms and financial
institutions dominate the swaps market, with few
(if any) individuals ever participating. Because
swaps occur on the OTC market, there is always
the risk of a counterparty defaulting on the swap.
SEE: Futures Fundamentals
The first interest rate swap occurred between
IBM and the World Bank in 1981. However,
despite their relative youth, swaps have exploded
in popularity. In 1987, the International Swaps
and Derivatives Association reported that the
swaps market had a total notional value of $865.6
billion. By mid-2006, this figure exceeded $250
trillion, according to the Bank for International
Settlements. That's more than 15 times the size
of the U.S. public equities market.
Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain
vanilla" interest rate swap. In this swap, Party A
agrees to pay Party B a predetermined, fixed rate
of interest on a notional principal on specific
dates for a specified period of time. Concurrently,
Party B agrees to make payments based on
a floating interest rate to Party A on that same
notional principal on the same specified dates for
the same specified time period. In a plain vanilla
swap, the two cash flows are paid in the same
currency. The specified payment dates are
called settlement dates, and the time between
are called settlement periods. Because swaps
are customized contracts, interest payments may
be made annually, quarterly, monthly, or at any
other interval determined by the parties.
SEE: How do companies benefit from interest
rate and currency swaps?
For example, on Dec. 31, 2006, Company A and
Company B enter into a five-year swap with the
following terms:
 Company A pays Company B an amount
equal to 6% per annum on a notional
principal of $20 million.
Company B pays Company A an amount
equal to one-year LIBOR + 1% per annum
on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the
interest rate offered by London banks on deposits
made by other banks in the eurodollar markets.
The market for interest rate swaps frequently (but
not always) uses LIBOR as the base for the
floating rate. For simplicity, let's assume the two
parties exchange payments annually on
December 31, beginning in 2007 and concluding
in 2011.
At the end of 2007, Company A will pay
Company B $20,000,000 * 6% = $1,200,000. On
Dec. 31, 2006, one-year LIBOR was 5.33%;
therefore, Company B will pay Company A
$20,000,000 * (5.33% + 1%) = $1,266,000. In a
plain vanilla interest rate swap, the floating rate is
usually determined at the beginning of
the settlement period. Normally, swap contracts
allow for payments to be netted against each
other to avoid unnecessary payments. Here,
Company B pays $66,000, and Company A pays
nothing. At no point does the principal change
hands, which is why it is referred to as a
"notional" amount. Figure 1 shows the cash flows
between the parties, which occur annually (in this
example).
SEE: Corporate Use Of Derivatives For Hedging
Figure 1: Cash flows for a plain vanilla interest
rate swap
Plain Vanilla Foreign Currency
Swap
The plain vanilla currency swap involves
exchanging principal and fixed interest payments
on a loan in one currency for principal and fixed
interest payments on a similar loan in another
currency. Unlike an interest rate swap, the parties
to a currency swap will exchange principal
amounts at the beginning and end of the swap.
The two specified principal amounts are set so as
to be approximately equal to one another, given
the exchange rate at the time the swap is
initiated.
For example, Company C, a U.S. firm, and
Company D, a European firm, enter into a five-
year currency swap for $50 million. Let's assume
the exchange rate at the time is $1.25
per euro (e.g. the dollar is worth 0.80 euro). First,
the firms will exchange principals. So, Company
C pays $50 million, and Company D pays 40
million euros. This satisfies each company's need
for funds denominated in another currency (which
is the reason for the swap).
Figure 2: Cash flows for a plain vanilla
currency swap, Step 1.
Then, at intervals specified in the swap
agreement, the parties will exchange interest
payments on their respective principal amounts.
To keep things simple, let's say they make these
payments annually, beginning one year from the
exchange of principal. Because Company C has
borrowed euros, it must pay interest in euros
based on a euro interest rate. Likewise, Company
D, which borrowed dollars, will pay interest in
dollars, based on a dollar interest rate. For this
example, let's say the agreed-upon dollar-
denominated interest rate is 8.25%, and the euro-
denominated interest rate is 3.5%. Thus, each
year, Company C pays 40,000,000 euros * 3.50%
= 1,400,000 euros to Company D. Company D
will pay Company C $50,000,000 * 8.25% =
$4,125,000.
As with interest rate swaps, the parties will
actually net the payments against each other at
the then-prevailing exchange rate. If, at the one-
year mark, the exchange rate is $1.40 per euro,
then Company C's payment equals $1,960,000,
and Company D's payment would be $4,125,000.
In practice, Company D would pay the net
difference of $2,165,000 ($4,125,000 -
$1,960,000) to Company C.
Figure 3: Cash flows for a plain vanilla
currency swap, Step 2
Finally, at the end of the swap (usually also the
date of the final interest payment), the parties re-
exchange the original principal amounts. These
principal payments are unaffected by exchange
rates at the time.
Figure 4: Cash flows for a plain vanilla
currency swap, Step 3
Who Would Use a Swap?
The motivations for using swap contracts fall into
two basic categories: commercial needs
and comparative advantage. The normal
business operations of some firms lead to certain
types of interest rate or currency exposures that
swaps can alleviate. For example, consider a
bank, which pays a floating rate of interest on
deposits (e.g. liabilities) and earns a fixed rate of
interest on loans (e.g. assets).
This mismatch between assets and liabilities can
cause tremendous difficulties. The bank could
use a fixed-pay swap (pay a fixed rate and
receive a floating rate) to convert its fixed-rate
assets into floating-rate assets, which would
match up well with its floating-rate liabilities.
Some companies have a comparative advantage
in acquiring certain types of financing. However,
this comparative advantage may not be for the
type of financing desired. In this case, the
company may acquire the financing for which it
has a comparative advantage, then use a swap
to convert it to the desired type of financing.
For example, consider a well-known U.S. firm
that wants to expand its operations into Europe,
where it is less known. It will likely receive more
favorable financing terms in the U.S. By then
using a currency swap, the firm ends with the
euros it needs to fund its expansion.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit
the swap prior to the agreed-upon termination
date. This is similar to an investor selling an
exchange-traded futures or option contract before
expiration. There are four basic ways to do this:
1. Buy Out the Counterparty: Just like an option
or futures contract, a swap has a
calculable market value, so one party may
terminate the contract by paying the other this
market value. However, this is not an automatic
feature, so either it must be specified in the
swaps contract in advance, or the party who
wants out must secure the counterparty's
consent.
2. Enter an Offsetting Swap: For example,
Company A from the interest rate swap example
above could enter into a second swap, this time
receiving a fixed rate and paying a floating rate.
3. Sell the Swap to Someone Else: Because
swaps have calculable value, one party may sell
the contract to a third party. As with Strategy 1,
this requires the permission of the counterparty.
4. Use a Swaption: A swaption is an option on a
swap. Purchasing a swaption would allow a party
to set up, but not enter into, a potentially
offsetting swap at the time they execute the
original swap. This would reduce some of
the market risks associated with Strategy 2.
The Bottom Line
Swaps can be a very confusing topic at first, but
this financial tool, if used properly, can provide
many firms with a method of receiving a type of
financing that would otherwise be unavailable.
This introduction to the concept of plain vanilla
swaps and currency swaps should be regarded
as the groundwork needed for further study. You
now know the basics of this growing area and
how swaps are one available avenue that can
give many firms the comparative advantage they
are looking for.
Interest Rate Swap
What is an 'Interest Rate Swap'
An interest rate swap is an agreement between
two counterparties in which one stream of future
interest payments is exchanged for another
based on a specified principal amount. Interest
rate swaps usually involve the exchange a fixed
interest rate for a floating rate, or vice versa, to
reduce or increase exposure to fluctuations in
interest rates or to obtain a marginally lower
interest rate than would have been possible
without the swap.
BREAKING DOWN 'Interest
Rate Swap'
A swap can also involve the exchange of one
type of floating rate for another, which is called a
basis swap.
Interest rate swaps are the exchange of one set
of cash flows for another. Because they trade
over the counter (OTC), the contracts are
between two or more parties according to their
desired specifications and can be customized in
many different ways. Swaps are often utilized if a
company can borrow money easily at one type of
interest rate but prefers a different type.
Fixed to Floating
For example, consider a company named TSI
that can issue a bond at a very attractive fixed
interest rate to its investors. The company's
management feels that it can get a better cash
flow from a floating rate. In this case, TSI can
enter into a swap with a bank counterparty in
which the company receives a fixed rate and
pays a floating rate. The swap is structured to
match the maturity and cash flow of the fixed-rate
bond, and the two fixed-rate payment streams
are netted. TSI and the bank choose the
preferred floating-rate index, which is usually
LIBOR for a one-, three- or six-month maturity.
TSI then receives LIBOR plus or minus a spread
that reflects both interest rate conditions in the
market and its credit rating.
Floating to Fixed
A company that does not have access to a fixed-
rate loan may borrow at a floating rate and enter
into a swap to achieve a fixed rate. The floating-
rate tenor, reset and payment dates on the loan
are mirrored on the swap and netted. The fixed-
rate leg of the swap becomes the company's
borrowing rate.
Float to Float
Companies sometimes enter into a swap to
change the type or tenor of the floating rate index
that they pay; this is known as a basis swap. A
company can swap from three-month LIBOR to
six-month LIBOR, for example, either because
the rate is more attractive or it matches other
payment flows. A company can also switch to a
different index, such as the federal funds rate,
commercial paper or the Treasury bill rate.
Asset Swap
An asset swap is similar in structure to a plain
vanilla swap, the key difference is the underlying
of the swap contract. Rather than regular fixed
and floating loan interest rates being swapped,
fixed and floating investments are being
exchanged.
BREAKING DOWN 'Asset Swap'
In a plain vanilla swap, a fixed libor is swapped
for a floating libor. In an asset swap, a fixed
investment such as a bond with
guaranteed coupon payments is being swapped
for a floating investment such as an index.
Liability Swap
An exchange of debt related interest rates
between two parties - usually large corporations.
In a liability swap, two currently identical (in
nominal value) cash flows are exchanged.
Usually a variable (floating) rate is exchanged for
a fixed rate of income. Swaps are undertaken
because each company receives a better rate of
interest by trading with the other than they would
if they chose a more traditional financing route.
BREAKING DOWN 'Liability
Swap'
For example, XYZ may swap a six-month LIBOR
interest rate for ABC's six-month fixed rate of 5%
on a notional principal of $10 million dollars. Due
to the split, XYZ will pay a fixed interest payment
of 5%, instead of the floating rate.
A swap will have an initial value of zero because
the initial cash flows are the same. Over time,
however, this will change as interest rates change
and the swap will have either a positive or
negative value for each contract holder. In certain
cases, the swap can be marked-to-market
periodically to clear out the unrealized gains and
losses by making any payments due.
Currency Swap
A currency swap, sometimes referred to as a
cross-currency swap, involves the exchange of
interest and sometimes of principal in one
currency for the same in another currency.
Interest payments are exchanged at fixed dates
through the life of the contract. It is considered to
be a foreign exchange transaction and is not
required by law to be shown on a company's
balance sheet.
BREAKING DOWN 'Currency
Swap'
A currency swap can be done in several ways. If
there is a full exchange of principal when the deal
is initiated, the exchange is reversed at
the maturity date. Currency
swap maturities are negotiable for at least 10
years, making them a very flexible method of
foreign exchange. Interest rates can be fixed or
floating.
Background
Currency swaps were originally done to get
around exchange controls. As most developed
economies have eliminated controls, they are
done most commonly to hedge long-term
investments and to change the interest rate
exposure of the two parties.
Pricing is usually expressed as LIBOR plus or
minus a certain number of points, based on
interest rate curves at inception and the credit
risk of the two parties.
Exchange of Principal
In a currency swap, the parties agree in advance
whether or not they will exchange the principal
amounts of the two currencies at the beginning of
the transaction. The two principal amounts create
an implied exchange rate. For example, if a swap
involves exchanging 10 million vs $12.5 million,
that creates an implied EUR/USD exchange rate
of 1.25. At maturity, the same two principal
amounts must be exchanged, which creates
exchange rate risk as the market may have
moved far from 1.25 in the intervening years.
Many swaps use simply notional principal
amounts, which means that the principal
amounts are used to calculate the interest
due and payable each period but is not
exchanged.
Exchange of Interest Rates
There are three variations on the exchange of
interest rates: fixed rate to fixed rate; floating rate
to floating rate; or fixed rate to floating rate. This
means that in a swap between euros and dollars,
a party that has an initial obligation to pay a fixed
interest rate on a euro loan can exchange that for
a fixed interest rate in dollars or for a floating rate
in dollars. Alternatively, a party whose euro loan
is at a floating interest rate can exchange that for
either a floating or a fixed rate in dollars. A swap
of two floating rates is sometimes called a basis
swap.
Interest rate payments are usually calculated
quarterly and exchanged semi-annually, although
swaps can be structured as needed. Interest
payments are generally not netted because they
are in different currencies.
 Currency Swap

Swap Rate
There are three different types of interest rate
exchanges for a currency swap: (1) the fixed rate
of one currency for a fixed rate of the second; (2)
the fixed rate of one currency to a floating rate of
A swap rate is the rate of the fixed leg of
the second; and (3) the floating rate of one to a
a swap as determined by its particular market. In
floating rate of the second. Within each of those
an interest rate swap, it is the fixed interest
three variations, there are two additional
rate exchanged for a benchmark rate such
variations: the swap can include or exclude a full
as LIBOR plus or minus a spread. It is also
exchange of the principal amount of currency at
the exchange rate associated with the fixed
both the beginning and the end of the swap. The
portion of acurrency swap.
interest rate payments are not netted because
they are calculated and paid in different
BREAKING DOWN 'Swap Rate'
currencies.
An interest rate swap is the exchange of a
floating rate for a fixed rate; a currency swap is Regardless of whether the principal is
the exchange of interest payments in one exchanged, a swap rate for the conversion of the
currency for those in another. In both types of principal must be set. If there is no exchange,
transaction, the fixed element is referred to as the then this is used simply for the calculation of the
swap rate. two notional principal currency amounts on which
the interest rate payments are based. If there is
Interest Rate Swap an exchange, where the swap rate is set can
Parties are referred to with respect to the fixed have a large profit or loss impact between the
rate leg of the swap; they are start and end dates of the swap
either payer or receivers of fixed. The cash flow
of the fixed rate leg of the swap is set when the
trade is done. The cash flow for the floating rate
leg is set periodically on the rate reset dates,
Estos son los elementos claves para evaluar una
which are determined by the reset period of the
floating rate leg. The most common index for the
floating rate leg is the three-month U.S. dollar firma de asset management
LIBOR. This can either be paid quarterly, so
31 OCTUBRE 2016 0 COMENTARIOS
every three months, or compounded and paid
semi-annually. The spread above or below
Una clara filosofa de inversin, un equipo
LIBOR reflects both the yield curve and
calificado y una visin a largo plazo son
any credit spread to be charged. Interest rate
algunos factores a considerar antes de entregar
payments between the fixed and the floating rate
un mandato de inversin.
legs are netted at the end of each payment
period, and only the difference is exchanged.
Detrs de una eficiente gestin de activos hay
mucho ms que comprar barato y vender caro.
Un buen asset manager es coherente con la
estrategia de inversin que defiende y entiende
cules son los objetivos del cliente y los riesgos
que est dispuesto a tomar. Qu aspectos
deben evaluarse antes de entregar un mandato
de inversin?
Una buena gestin de inversiones
requiere disciplina y orden: seguir una
secuencia lgica. En primer lugar, el gestor
debe conocer cul es el mandato de inversin
que se est tomando por encargo. Un mandato
refleja regulacin, apetito por riesgo y
objetivos, y depende del perfil del cliente o del
diseo de la poltica de inversin del asset
manager. Luego, debe quedar claro qu
riesgos pueden asumirse y qu vehculos se
utilizarn para alcanzar los objetivos.
Un aspecto clave antes de encargarle la gestin
de los propios fondos a un asset manager es
la evaluacin de su trabajo y visin. Sin
embargo, esta tarea se pasa muchas veces por
alto y, cuando se realiza, la aproximacin ms
comn es la cuantitativa. Es decir, se evala la
data histrica de cada gestor para entender qu
tanto alpha (retorno por encima
del benchmark) ha producido en el tiempo,
cun estables son sus rendimientos y cul es la
relacin entre los retornos generados y los
riesgos asumidos.
Sin embargo, el anlisis de los resultados
histricos resulta muchas veces
insuficiente. Wilshire Advisors una
consultora de inversiones con sede en Santa
Mnica, California evalu el desempeo de de ejecutivos si desea permanecer en la
diversos gestores globales del 2006 al 2015. De
los que estuvieron en el cuartil superior
durante el perodo 2006-2010, apenas el 35%
se mantuvo en dicho cuartil en el quinquenio
sucesivo (2011-2015). Otros estudios arrojan
similares resultados: la performance es rara vez
persistente. En promedio, un gestor con un
buen desempeo pasado no aumenta sus
probabilidades de repetirse en el futuro.
ARTCULO RELACIONADOPor qu las
personas no suelen ahorrar?
Roberto Melzi, CIO de SURA Investment
Management, seala que la clave est
en entender la filosofa de inversin
del managery el trabajo de su equipo. Qu
haces en el da a da para honrar esa filosofa?
Qu haces cuando tu filosofa est en estrs y
enfrentas una situacin en la que pierdes
dinero o te encuentras debajo del benchmark?
Cumples con el mandato que fijaste desde un
principio, asegura el ejecutivo. La evidencia
demuestra que los gestores ms eficientes en el
largo plazo son aquellos que siempre han hecho
lo que dijeron que iban a hacer. En momentos
de estrs, son los primeros en defender la tesis
por la que sus clientes confiaron en ellos en
primer lugar.
Sin la filosofa correcta, que se sostiene en la
disciplina y el coraje para llevarla a cabo, la
gestin de fondos no tiene sentido, resalta en
un reciente artculo Schroders, una empresa
britnica de asset management con ms de
343,800 millones en activos administrados.
Una firma de gestin de fondos debe adems
preocuparse de planificar una slida sucesin
industria por 200 aos o ms y generar
rendimientos a largo plazo, subraya Schroders,
fundada nada menos que en 1804.
En la misma lnea, la multinacional
financiera Barclays recomienda evaluar cmo
se toman las decisiones de inversin en una
empresa gestora antes de otorgarle un
mandato. Las decisiones sobre el fondo las
toma un equipo calificado de
profesionales, regidos por una filosofa de
inversin que trasciende a los encargados de
turno? O las toma un solo manager estrella,
apoyado por analistas sin voz ni voto en el
proceso decisional? El segundo caso implica el
denominado riesgo demanager, es decir, el
riego de que el responsable de la buena
performance de un fondo no pueda continuar,
ya sea porque renuncia al cargo, se retira, etc.
Un claro ejemplo de esto ltimo ocurri en
2013, cuando Neil Woodford,
el manager estrella de Invesco Perpetual,
se retir para formar su propia firma. En los
tres meses posteriores al anuncio, los
inversionistas retiraron un total de 2,500
millones de los fondos de Invesco.
Una clara filosofa de inversin, un equipo
calificado que asuma la toma de decisiones, y
una consistencia de largo plazo para seguir las
estrategias establecidas son algunos de los
elementos claves que deben considerarse
cuando se evala una firma de asset
management. La performance histrica
puede dar alguna pista, pero por s sola resulta
insuficiente para predecir el futuro
Info economica:
Premio Nobel de Economa: cmo
todos pueden beneficiarse?
Oliver Hart y Bengt Holmstrm ganaron
el Premio Nobel de Economa 2016 por
disear mecanismos que permiten que todas
las partes ganen tras la firma de un contrato
Ayer el economista britnico Oliver Hart y el
economista finlands Bengt Holmstrm
ganaron el Premio Nobel de Economa por
sus aportes para resolver el problema de la
incertidumbre entre dos partes que firman un
contrato.
El mundo est golpeado por la incertidumbre
y el premio es reconocimiento a su gran
trabajo, seala Mximo Torero, economista
peruano y director de la divisin de mercados,
comercio e instituciones en el Instituto
Internacional de Investigaciones sobre Polticas
Alimentarias (IFPRI). El premio debieron
habrselo dado hace muchos aos. Para m y
varios colegas es cosa de todos los das aplicar
los trabajos de Hart y Holmstrm. Son unos
gigantes en su profesin, dice Roberto Chang,
economista peruano y profesor del
departamento de economa de Rutgers
University en Estados Unidos.
Las aplicaciones
Es comn que en una interaccin una persona
tenga mayor informacin que la otra y que, por
ello, obtenga una ventaja en una eventual
interaccin econmica. Este problema se
conoce tcnicamente como informacin
asimtrica. Lo que Hart y Holmstrn han
hecho durante su vida acadmica, y por lo que
han ganado el Nobel de Economa, es disear
mecanismos que solucionen la informacin
asimtrica en los contratos. Algunos de estos
mecanismos son incentivos. El resultado:
mejorar la calidad de contratos que suscriben
dos personas para que ambas ganen en las
transacciones econmicas.
Un ejemplo clsico de informacin asimtrica
es el del empleador y el empleado. El
empleador contrata a un trabajador para
realizar una actividad; sin embargo, el primero
no puede observar directamente el trabajo y
esfuerzo del segundo, lo cual puede conllevar a
que el objetivo final no se cumpla. Para
solucionar este problema de asimetra, la
remuneracin de los CEO est compuesta
tambin por acciones. De esta manera, los
accionistas incentivan al CEO a que la empresa
tenga un buen desempeo, lo que eleva el valor
de la accin y beneficia al propio CEO.
ARTCULO RELACIONADONobel de Economa
2016: Oliver Hart y Bengt Holmstrm
obtuvieron el premio
Pero como un evento favorable o negativo fuera
del control de la empresa puede beneficiarla o
perjudicarla ms all del desempeo del
CEO, Holmstrm cre el premio al desempeo
relativo. Este premio materializable en bonos
evala tambin el resultado de empresas
similares. Por ejemplo, si se da una ley como
la del retiro [de fondos] de las AFP, que afecta
la industria en general, no sera lgico castigar
al CEO [de una AFP], sostiene Torero.
El mecanismo de los incentivos trabajado por
Hart y Holmstrm tambin se aplica en un
contrato entre un contratante y un contratado.
En el mercado de seguros, por ejemplo, si no se
asegura un conductor al 100%, se le incentiva a
ser ms precavido.
El reconocimiento al trabajo de Hart y
Holmstn se suma a los de Vickrey y Mirrless
(Premios Nobel en 1996) y Akkerlof, Spence y
Stiglitz (Premios Nobel de Economa en el
2001) que tambin aportaron para
solucionar el problema de la informacin
asimtrica en los mercados.
1 Info mundial
2 Info continentes
En Asia, la ciada luego de que e l
presidente fancorsue dijo a la UE deba
matnenr acuerdo con los britnicos,.
3 Info pases importantes:
Inglaterra:
1 Britain's Pound Just 'Flash
Crashed' to a 31-Year Low of $1.15
Sterling plunged to a 31-year low in a matter
of minutes on Friday, i En el mes de
ocurbre la libra esternlina sufrio una
flash crahs debido las ordenes de
venta lo que hcicieron su pero semna
desde el voto del bresit en junio. Hay
mucha anideda por la dificl salida que
tendr el la libra de la unin europea.
Segn thomso reutors que maneja un
su propia platdolarmade brker
extranjera, su cotizaicon fue la mas
baja reviasad a 1.1491 inferiro incluso
a la del 1985.
El mercado ve a la volaitade overnigth
de la libra es resutlado de lpreisden
 hoolnade frenacia demnadando fuerte
negociaicone del brexit.
4 Info AL
5 Peru
Alfredo Thorne: ley de 'IGV justo' beneficiar a las
grandes empresas
Compartir Twittear Compartir Compartir
El titular del MEF espera que los congresistas
reconsideren su apoyo a la medida en segunda
votacin.
El ministro de Economa y Finanzas, Alfredo
Thorne, se mostr una vez ms en contra del
proyecto de ley denominado IGV Justo, que
permite a las empresas que tengan ventas
anuales de hasta 1,700 UIT (ms de S/.6
millones) acceder a una prrroga del pago de
este impuesto por tres meses (noventa das).
En entrevista con el diario Gestin, el titular
del MEF afirm que la propuesta
legislativa,aprobada la semana pasada en
el Pleno del Congreso, beneficiar a las grandes
empresas.
El IGV justo no slo es un problema de
recaudacin, sino tambin de justicia. Nosotros
bajamos el umbral a 300 UIT [en el debate de
facultades legislativas] porque el umbral a
1,700 UIT realmente estara beneficiando a las
grandes empresas, afirm Thorne.
Su cartera ya ha advertido anteriormente que
el IGV justo afectara la recaudacin
tributariay hara perder al fisco ms de
S/.1,100 millones. As, espera que los
congresistas recapaciten en la segunda
votacin, que ocurrir esta semana.
ARTCULO RELACIONADOCongreso aprob
en primera votacin proyecto del IGV
justo
El alto funcionario reconoci no slo la falta de
acuerdos con el Congreso, sino tambin con
otros ministerios, como el de Produccin.
Debemos poder decidir qu cosa es una mype
y qu cosa es una pyme. No es correcto que un
ministerio como Produce defina las mypes
como 1,700 UIT cuando sabemos que lo que
queda por encima de esas 1,700 UIT son
12,000 empresas de un total de 1.75 millones,
indic.
Adems, Thorne sostuvo que el proyecto de ley
dificultara la reforma del factoring que su
gestin est trabajando, en el marco de las
facultades legislativas.
Nosotros vamos a hacer algunos ajustes a la
reforma de las facturas que permitir a las
pymes y mypes vender sus facturas en la BVL.
Las empresa van a poder conseguir efectivo
sobre sus facturas. El IGV Justo confunde un
poco las cosas y les quita esa ventaja a las
mypes y pymes de poder vender sus facturas,
argument al medio local.
Dolarizacin del crdito aumenta en las grandes
empresas
19 OCTUBRE 2016 0 COMENTARIOS
La dolarizacin del crdito se mantiene
en 32% y sube en las empresas
corporativas.La estabilidad cambiaria y la
mayor actividad exportadora lo propician.
Las tasas en dlares siguen
bajas, y eso lleva a tomar
deudas en esa moneda
Las grandes empresas corren un mayor
riesgo de sufrir prdidascambiarias a
mediano plazo de no tomar coberturas,
pues estn aumentando su proporcin de
deuda en dlares pese a que el tipo de
cambio podra subir en el 2017.
La dolarizacin de las empresas
corporativas pas de 38% al cierre del
2015 a 41% en agosto pasado, segn
la SBS. En todo el sistema bancario, la
dolarizacin se ha estancado en 32% en
el 2016.
La mayor dolarizacin corporativa se
debe, en parte, a la estabilidad que ha
mostrado el tipo de cambio este ao. La
depreciacin [del sol] se revirti, por lo
que las tendencias de la desdolarizacin
pararon, anot Julio Villavicencio,
director de estrategia de Credicorp
Capital. Tambin se debe a las an bajas
tasas en dlares. Son cercanas a 7.6%
anual, mientras que las tasas en soles
alcanzan el 18%, segn la SBS.
ARTCULO RELACIONADODolarizacin del
crdito fue de 30% en agosto, inform el
BCR
El endeudamiento en dlares afectara
ms a las empresas no exportadoras. El
24% de la cartera de los crditos en
dlares de los bancos proviene de este
tipo de empresas, que son las que estn
expuestas a riesgos cambiarios. En el
pasado, las prdidas por descalces
cambiarios ya las han afectado (SE
1508).
Por otro lado, las exportadoras que slo
representan el 8% del sistema pueden
tomar mayor deuda en dlares, pues sus
ingresos estn en esta moneda, segn
Alberto Morisaki, gerente de estudios
econmicos de Asbanc. As lo han hecho
para financiar sus operaciones. La
dolarizacin debera estar cercana al
10%, como en Chile y Colombia, aade
Morisaki, en referencia a la
representacin de las exportadoras. Ello
denotara que an hay espacio para
reducir la dolarizacin. (JMH/AI)
 ng statment of
standard comphensive income.
.
-it The diferenc between
rpresents comprenhension
and cincome and other
captures comprehensive income.
the In financial accounting
eocmics income is brken down in a
of a multitud of ways ,and
trnsancito firmas have som latitud on
n better. when to recognize an
-It s drprot their earnings.
common
global -to compensate for this,
language the Finantial
for accounting standars
compnay board(FASB) has firms
accountin collect and report
g affaird indromation that helps
-SEC has to provide perspective
expressed for investors and
IFRS US GAAP a desire analysist.
The standards that govern finantial to swich 2 such measumenret are
reporting and accounting vary from rom GAAP comphensive income and
cpuntry to country. to IFRS. other comphensive
In the USA finantial rrproting practicaes IFRS income.
ar set forth by the Finanical acounting guidelines Comprehensive Income
standard board(FASB). And organizaed provide
Comprehensive income is
wothin the framework of the generally much less
accpeted acounting prinicple or GAAP. overall used to measure the change
detail tan in an owner's interest in a
Both has differencesin details and GAAP
business. This is done by
interpretations. So the
The emeotdology is the rpimary theoritical charting the change in a
deifencen between the 2 systems.: framewor company's net assets from
- k an nonowner sources,
dprinciple
of the including all income and
IFRS leave expenses that usually
-The -inventry costs: GAAP is mre room bypass the income
accountin rules based. for the
statement because they
g -GAAPS rules allow for intepretati
standard LIFO(UEPS), FIFO(PEPS) on and have not yet been realized.
used in and the Weighted average may often Comprehensive income is
more tan cost method(WACM) require
normally listed in a separate
110 GAAP doesno allow fro lengthy
cpuntries. inventary reversals, while disclosure statement than income,
-is more IFRS permits tthem under s onf which does include
principle centain conditions. finantial changes in owner equity.
s based -GAAP requires financial statments
. Comprehensive income is
accounti statments to include a
- it is calculated by=net income + es: stamtment
conisstne
the sum of recognized The finantial stamtment
n and II)Invento
intuitueve revenues - the sum of ry costs: notes invlving the eqeuity
prinicples recognized expenses, the most section will detail the varior
ar more notable
+other comprehensive changes to owners equity
logically deifferenc
soudn and income. e beteeen fro the period. In the notes ,
may Comprehensive income: GAAP and a compny will typically explain
posible It is a part of the owners IFRS the changes to owners that
better invlves
represent equity section of the balance their resulted rom the ordinay
the sheet(assets, liabilities owner inventary. coruse of businees. It will also
ocnmics equity notes:4 sections). Tratments dtail the changes that result
of .
It represets the changes to romo non.owner soruces.
business IFRS rules
trnsacctio owners equity that occur ban the The sum of thes two amounts
ns. during an accunting period use of last is comprehnsive income
thath com from= non in, first The accountinf treatment of
-IFRS does outLIFO( comphensive income is
nit owner soruces, + the UEPS) but established in the statment of
consider income fromo more traitional allows the
fianncial accounting standars
e means sucha as net FIFOfirst
N130,according to this any
cimpehe in and
nsve
operating income. first income is comphensive if it
income There are 4 spruces of non- out(PEPS) changes the equity of a
to be a owner changes to owner And business Enterprise wthou
major WACM involving an owner
eqeuity. They are:
ellemnt investment or creating a
of 1)adjustments to markeatble III)Write dsitribution to an owner
performa securities the compnay holds downs -ex:any held investment
nce and for sale classified as avaliable for sale
thereore wihc s is nonderivative asset
dens 2)foreign cucrrency trnasction
not intended to be held until
inlcude adjustments,
maturity and is not a loan or
it.. 3)adjustment to a reequired recivable, can crate
-this
minmum pension liability recognizable comprehensive
leaves
somo 4)value changes in future income. Any change in the
room for contract thar are hedged value of the avaliable for sale
miximg asset can be included.
pistions.
owner -foreigns currency trnasactosn
and Income from these non- can crate gains ir losses if the
nowner owner soruces results in an bal ce of a compnay currency
actviity incresae in teh value of the holdings fluctuates which they
within often do.. this is special fro
the
compnay nomal line of
large compnies with delaings in
inancial business , the FASB
many different currencies.
stamtme considers it inappropiate to Pension plans can slso crate
nts
include this tupe of income comphensive income if the
I)Intngibl in the tradiction income value of the epnsion plan
increase.
Comprehensive
ncome (or earnings) is a
specific term used in companies'
financial reporting from the
company-whole point of view.
Because that use excludes the
effects of changing ownership
interest, an economic measure
of comprehensive income is
necessary for financial analysis
from the shareholders' point of
view (All changes in Equity
except those resulting from
investment by or distribution to
owners.)
Comprehensive income is
defined by the Financial
Accounting Standards Board, or
FASB,[1] as the change in equity
[net assets] of a business
enterprise during a period from
transactions and other events
and circumstances from non-
owner sources. It includes all
changes in equity during a
period except those resulting
from investments by owners and
distributions to owners.
Comprehensive income is the
sum of net income and other
items that must bypass
the income statement because
they have not been realized,
including items like an
unrealized holding gain or loss
from available for
sale securities and
foreign currency translation
gains or losses. These items are
not part of net income, yet are
important enough to be included
in comprehensive income, giving
the user a bigger, more
comprehensive picture of the
organization as a whole.
Items included in
comprehensive income, but
not net income are reported
under the accumulated other
comprehensive income section
of shareholder's equity.
Comprehensive income
attempts to measure the sum
total of all operating and
financial events that have
changed the value of an owner's
interest in a business. It is
measured on a per-share basis
to capture the effects of dilution
and options. It cancels out the
effects of equity transactions for
which the owner would be
indifferent; dividend payments,
share buy-backs and share
issues at market value.
It is calculated by reconciling the
book value per-share from the
start of the period to the end of
the period. This is conceptually
the same as measuring a child's
growth by finding the
difference between his height
on each birthday. All other line
items are calculated, and the
equation solved for
comprehensive earnings
Shareholders' Equity, beg. of
period (per share)
- Dividends paid (per share)
+ Shares issued
(premium over book value
per share)
- Share buy-backs
(premium over book value
per share)
+ Comprehensive
Income (per share)
------------------------
------------------
= Shareholders'
Equity, end of period
(per share)
It is a reporting comphensive
income. This statement
required all income
statement items to be
reported either as a regular
item in the income statement
or a special item as other
comprehensive income. It is
commonly referred to as
FAS130.
Comprehensive income is the
total non-owner change in equity
for a reporting period.
This change encompasses all
changes in equity other than
transactions from owners and
distributions to owners. Most
of these changes appear in the
income statement.
A few special types of gains and
losses are not shown in the
income statement but as special
items in shareholder equity
section of the balance sheet.
Since these comprehensive
income items are not closed to
retained earnings each period
they accumulate as shareholder
equity items and thus are
entitled Accumulated Other
Comprehensive Income and is
sometimes referred to as
"AOCI".
Accumulated other
comprehensive income is a
subsection in equity where
"other comprehensive income" is
accumulated (summed or
"aggregated").
The balance of AOCI is
presented in the Equity section
of the Balance Sheet as is the
Retained Earnings balance,
which aggregates past and
current Earnings, and past and
current Dividends.
Other comprehensive
income[edit]
Other comprehensive income is
the difference between net
income as in the Income
Statement (Profit or Loss
Account) and comprehensive
income, and represents the
certain gains and losses of
the enterprise not recognized in
the P&L Account. It is commonly
referred to as "OCI".
In practice, it comprises the
following items:
1. Unrealized gains and
losses on available for
sale securities [IAS
39/ "FAS 115" -
"Accounting for Certain
Investments in Debt and
Equity Securities"]
2. Gains and losses
on derivatives held
as cash flow
hedges (only for
effective portions) [IAS
39/ "FAS 133" -
"Accounting for
Derivative Instruments
and Hedging Activities"]
3. Gains and losses
resulting from
translating the financial
statements of foreign
subsidiaries (from
foreign currency to the
presentation currency)
[IAS 21/ "FAS 52" -
"Foreign Currency
Translation"],
4. Actuarial gains and
losses on defined
benefit plans recognized
(Minimum pension liabili
ty adjustments) [IAS
19/ "FAS 158" -
"Employers' Accounting
For Defined Benefit
Pension And Other
Postretirement Plans"]
5. Changes in
the revaluation surplus
 [IAS 16 and IAS 38]
While the AOCI balance is
presented in Equity section of
the balance sheet, the annual
accounting entries, as flows,
are presented sometimes in
a Statement of Comprehensive
Income.
This statement expands the
traditional Income
Statement beyond Earnings to
include OCI in order to present
Comprehensive Income.
Under the revised IAS 1, all non-
owner changes in equity
(comprehensive income) must
be presented either in one
Statement of comprehensive
income or in two statements (a
separate income statement and
a statement of comprehensive
income)
In the third quarter of 2008 the
United States Securities and
Exchange Commission received
several proposals to allow the
recognition in AOCI of certain
fair value changes on financial
instruments. This proposal was
initially well received by
representatives of the banking
community who felt that
Earnings recognition of these
fair value changes during the
concurrent "credit meltdown of
2008" would be inappropriate.
The effect of this proposal, on
balance, would be to remove
sizeable losses from Earnings
and thus Retained Earnings of
banks, and assist them in
preserving their regulatory
capital. The regulatory capital of
banks in the US and generally
worldwide includes contributed
equity capital and retained
earnings but excludes AOCI,
even though it is reported as a
component of the Equity section
of the Balance Sheet.
Other Comprehensive
Income
Aaccount like revenues,
epenser gains an dlooses
that haven no yet
relaized(not sold)
Ej: a prtofoilio of bondsa hath
has not been sold. Gains and
losses from changng value of
the bonds cannot be realized
until they are sold. So the
intemrim adjsutment are
recognized in other
comprehnesive income.
Other comprehensive
income is a catch-all for all
of the items that cannot be
included in typical profit
and loss calculations.
Examples of the types of
changes captured by other
comprehensive income
include:
Gains and losses
from derivative
instruments
Debt
security unrealized
gains and losses
Pension or other
retirement plan gains
and losses
Foreign currency
transaction adjustme
nts

Available-for-sale
securities unrealized
gains and losses
These items occur rather
infrequently for smaller
businesses, so other
comprehensive income is
most important for valuing
larger corporations.
Watching the unrealized
performance of a firm's
investment portfolio can
reveal the possibility of
major losses down the
road. You can see how
overseas operations and
currency hedging affects
corporate performance.
Comprehensive income
and other comprehensive
income help bring
complicated financial
reporting into a clearer view.
the differences
between Difference
between Net Income,
Comprehensive Income
and Other
Comprehensive Income.
Net income = Companys
earnings after taxation
whereby earnings before
taxation is difference
between total revenues
and total expenses during
period (fiscal year)
Accounting statements
set is concerned by basic
accounting reports such
as balance sheet and profit
and loss or income
statement.
Net income of the year is
part of P/L statement
but finally also appears
in BS in equity position
(equity position is part of
BS not PL).
Other comprehensive
income is GAAP (both
USGAAP and IFRS) equity
extension for changes on
equity which
bypass(obvia)PL and thus
such transactions are not
concerned in net income
of the year. Eg. actuarial
gains and losses,
revaluation surplus
account, net exchange
differences from
investments to foreign
subsidiary, etc.
Total comprehensive
income or just
comprehensive
income=sum of net
income of the year
(through P/L)+ other
comprehensive income.
The intention of standard
bodies while
implementing other
(total) comprehensive
income to set of
mandatory report
statements was higher
transparency and
reducing misreporting
issues.
Statement of
changes in equity
A Statement of changes in
equity and similarly
the statement of changes in
owner's equity for a sole
trader, statement of changes
in partners' equity for
a partnership, statement of
changes in Shareholders'
equity for
a Company or statement of
changes in Taxpayers'
equity[1] for Government
financial statements is one of
the four basic financial
statements.
The statement explains the
changes in a company's Share
Capital, accumulated
reserves and retained
earnings over the reporting
period. It break down changes in
the owners' interest in the
organization, and in the
application of retained profit or
surplus from one accounting
period to the next. Line items
typically include profits or losses
from operations, dividends paid,
issue or redemption of
shares, revaluation reserve and
any other items charged or
credited to accumulated other
comprehensive income. In also
includes the Non-Controlling
Interest attribuable to other
individuals and organisations.
The statement is expected under
the generally accepted
accounting principles and
explain the owners'
equity shown on the balance
sheet, where:
owners' equity = assets
liabilities
Requirements of the
U.S. GAAP[edit]
In the United States this is called
a statement of retained
earnings and it is required under
the U.S. Generally Accepted
Accounting Principles (U.S.
GAAP) whenever comparative
balance sheets and income
statements are presented. It
may appear in the balance
sheet, in a combined income
statement and changes in
retained earnings statement, or
as a separate Schedule
Therefore, the statement of
retained earnings uses
information from the income
statement and provides
information to the balance sheet.
Retained earnings are part of
the balance sheet (another basic
financial statement) under
"stockholders equity
(shareholders' equity)" and is
mostly affected by net income
earned during a period of time
by the company less any
dividends paid to the company's
owners / stockholders. The
retained earnings account on
the balance sheet is said to
represent an "accumulation of
earnings" since net profits and
losses are added/subtracted
from the account from period to
period.
Retained Earnings are part of
the "Statement of Changes in
Equity". The general equation
can be expressed as following:
Ending Retained
Earnings
= Beginning Retained
Earnings Dividends
Paid + Net Income
This equation is necessary to
use to find the Profit Before Tax
to use in the Cash Flow
Statement under Operating
Activities when using the indirect
method. This is used whenever
a comprehensive income
statement is not given but only
the balance sheet is given
Requirements of
IFRS[edit]
IAS 1 requires a business entity presented in the notes instead of
to present a separate statement presenting in the statement of
of changes in equity (SOCE) as changes in equity.
one of the components of
financial statements. However, the amount of
dividends recognised as
The statement shall show: distributions, and the related
(IAS1.106) amount per share, may be
presented in the notes instead of
1. total comprehensive presenting in the statement of
income for the period, changes in equity. (IAS1.107)
showing separately
amounts attributable to For small and medium
owners of enterprises (SMEs), the
the parent and to non- statement of changes in equity
controlling interests should show all changes in
equity including:
2. the effects of
retrospective total comprehensive
application, when income
applicable, for each
component owners' investments

3. reconciliations between dividends

the carrying amounts at
the beginning and
the end of the period for owners' withdrawals of
each component capital
of equity, separately
disclosing: treasury share
transactions
profit or loss
They can omit the statement of
each item of other changes in equity if the entity
has no owner investments or
comprehensive
withdrawals other than
income
dividends, and elects to present
a combined statement of
transactions with
comprehensive income and
owners, showing retained earnings.
separately
contributions by and
distributions
to owners and
Income
changes in
ownership interests
statement
in subsidiaries
that do not result in An income statement or profit
a loss of control and loss account [1] (also
referred to as a profit and loss
statement (P&L), statement of
However, the amount of
profit or loss, revenue
dividends recognised as
statement, statement of
distributions, and the related
financial
amount per share, may be
performance, earnings

statement, operating
statement, or statement of
operations)
is one of the financial
statements of a company and
shows the
companys revenues and expen
ses during a particular period.
It indicates how the revenues
(money received from the sale
of products and services before
expenses are taken out, also
known as the top line) are
transformed into the net
income (the result after all
revenues and expenses have
been accounted for, also known
as net profit or the bottom
line). It displays the revenues
recognized for a specific period,
and
the cost and expenses charged
against these revenues,
including write-offs (e.g., depreci
ation and amortization of
various assets) and taxes.[2] The
purpose of the income
statement is to
show managers and investors w
hether the company made or
lost money during the period
being reported.
One important thing to
remember about an income
statement is that it represents a
period of time like the cash flow
statement. This contrasts with
the balance sheet, which
represents a single moment in
time.
The income statement can be
prepared in one of two
methods.[3] The Single Step
income statement takes the
simpler approach, totaling
revenues and subtracting
expenses to find the bottom
line. The more complex Multi-
Step income statement takes
several steps to find the
bottom line, starting with
the gross profit. It then
calculates operating
expenses and, when deducted
from the gross profit, yields
income from operations. Adding
to income from operations is
the difference of other
revenues and other expenses.
When combined with income
from operations, this yields
income before taxes. The final
step is to deduct taxes, which
finally produces the net
income for the period
measured.
Usefulness and
limitations of income
statement[edit]
Income statements should
help investors and creditors
determine the past financial
performance of the enterprise,
predict future performance,
and assess the capability of
generating future cash flows
through report of the income
and expenses.
However, information of an
income statement has several
limitations:
Items that might be
relevant but cannot be
reliably measured are not
reported (e.g., brand
recognition and loyalty).
Some numbers depend
on accounting methods
used (e.g., using FIFO or
LIFO accounting to
measure inventory level).
Some numbers depend
on judgments and
estimates
(e.g., depreciation expens
e depends on estimated
 useful life and salvage
value).
Guidelines for statements of
comprehensive income and
income statements of business
entities are formulated by
the International Accounting
(IASB)Standards Board and
numerous country-specific
organizations, for example
the FASB in the U.S..
Names and usage of different
accounts in the income
statement depend on the type
of organization, industry
practices and the
requirements of different
jurisdictions.
If applicable to the business,
summary values for the
following items should be
included in the income
statement:[4]
Operating section[edit]
Revenue - Cash
inflows or other
enhancements of assets
(including accounts
receivable) of an entity
during a period from
delivering or producing
goods, rendering services,
or other activities that
constitute the entity's
ongoing major operations.
It is usually presented as
sales - sales discounts,
returns, and allowances.
Every time a business sells
a product or performs a
service, it obtains revenue.
This often is referred to as
gross revenue or sales
revenue.[5]
Expenses - Cash
outflows or other using-up
of assets or incurrence of
liabilities
(including accounts payable)
during a period from
delivering or producing
goods, rendering services,
or carrying out other
activities that constitute the
entity's ongoing major
operations.
Cost of Goods
Sold (COGS) / Cost of
Sales - represents the
direct costs
attributable to goods
produced and sold by
a business
(manufacturing or
merchandizing). It
includes material
costs, direct labour,
and overhead
costs (as in absorption
costing), and excludes
operating costs (period
costs) such as selling,
administrative,
advertising or R&D,
etc.
Selling, General
and Administrative
expenses (SG&A or
SGA) - consist of the
combined payroll
costs. SGA is usually
understood as a major
portion of non-
production related
costs, in contrast to
production costs such
as direct labour.
Selling
expenses -
represent
expenses needed
to sell products
(e.g., salaries of
sales people,
commissions and
travel expenses,
advertising, freight,
shipping,
 depreciation of (IAS 1.99) If an entity
sales store categorises by function, then
buildings and additional information on the
equipment, etc.). nature of expenses, at least,
depreciation, amortisation and
General employee benefits expense
and Administrative must be disclosed. (IAS 1.104)
(G&A) expenses -
represent The major exclusive of costs
expenses to of goods sold, are classified
manage the as operating expenses. These
business (salaries represent the resources
of officers / expended, except for
executives, legal inventory purchases, in
and professional generating the revenue for the
fees, utilities, period. Expenses often are
insurance, divided into two broad sub
depreciation of classicifications selling
office building and expenses and administrative
equipment, office expenses.[5]
rents, office
supplies, etc.). Non-operating
Depreciation / A
section[edit]
mortization - the
charge with respect Other revenues or
to fixed gains - revenues and gains
assets / intangible from other than primary
assets that have been business activities
capitalised on (e.g., rent, income from
the balance sheet for a patents, goodwill). It also
specific (accounting) includes unusual gains that
period. It is a are either unusual or
systematic and infrequent, but not both
rational allocation of (e.g., gain from sale of
cost rather than the securities or gain from
recognition of market disposal of fixed assets)
value decrement.
Other expenses or
Research & losses - expenses or
Development (R&D) losses not related to
expenses - represent primary business
expenses included in operations, (e.g., foreign
research and exchange loss).
development.
Finance costs - costs
Expenses recognised in the of borrowing from various
income statement should be creditors (e.g., interest
analysed either by nature (raw expenses, bank charges).
materials, transport costs,
staffing costs, depreciation, Income tax expense -
employee benefit etc.) or sum of the amount
by function (cost of sales, of tax payable to tax
selling, administrative, etc.).
 authorities in the current
reporting period (current tax
liabilities/ tax payable) and
the amount of deferred
tax liabilities (or assets).
Irregular items[edit]
They are reported separately
because this way users can
better predict future cash
flows - irregular items most
likely will not recur. These are
reported net of taxes.
Discontinued
operations is the most
common type of irregular
items. Shifting business
location(s), stopping
production temporarily, or
changes due to
technological improvement
do not qualify as
discontinued operations.
Discontinued
operations must be shown
separately.
Cumulative effect of changes
in accounting policies
(principles) is the difference
between the book value of the
affected assets (or liabilities)
under the old policy (principle)
and what the book value
would have been if the new
principle had been applied in
the prior periods. For example,
valuation of inventories
using LIFO instead
of weighted average method.
The changes should be
applied retrospectively and
shown as adjustments to
the beginning balance of
affected components
in Equity. All comparative
financial statements should be
restated. (IAS 8)
However, changes in
estimates (e.g., estimated
useful life of a fixed asset) only
requires prospective changes.
(IAS 8)
No items may be presented in
the income statement
as extraordinary items under
IFRS regulations, but are
permissible under US GAAP.
(IAS 1.87)
Extraordinary items are both
unusual (abnormal) and
infrequent, for example,
unexpected natural disaster,
expropriation, prohibitions
under new regulations.
Additional items may be needed
to fairly present the entity's
results of operations. (IAS 1.85)
Disclosures[edit]
Certain items must be
disclosed separately in the
notes (or the statement of
comprehensive income), if
material, including:[4] (IAS 1.98)
Write-downs
of inventories to net
realisable value or
of property, plant and
equipment to recoverable
amount, as well
as reversals of such write-
downs
Restructurings of the
activities of an entity
and reversals of any
provisions for the costs of
restructuring
Disposals of items of
property, plant and
equipment
Disposals of
investments
Discontinued
 operations
Litigation settlements represents the profit for the
Other reversals of shareholders.
provisions
Earnings per share[edit]
Because of its
importance, earnings per
share (EPS) are required to be
disclosed on the face of the
income statement. A company
which reports any of the
irregular items must also
report EPS for these items
either in the statement or in
the notes.
There are two forms of EPS
reported:
Basic: in this case beginning on or after 1
weighted average of January 2009.
shares outstanding
includes only actual
stocks outstanding.
Diluted: in this case
weighted average of
shares outstanding is
calculated as if all stock
options, warrants,
convertible bonds, and
other securities that could
be transformed into
shares are transformed.
This increases the number
of shares and so EPS
decreases. Diluted EPS is
considered to be a more
reliable way to measure
EPS.
Bottom line[edit]
Bottom line is the net
income that is calculated after
subtracting the expenses from
revenue. Since this forms the
last line of the income
statement, it is informally
called bottom line. It is
important to investors as it
year attributable to the
After revision to IAS 1 in 2003,
the Standard is now
using profit or loss for the
year rather than net profit or
loss or net income as the
descriptive term for the bottom
line of the income statement.
Requirements of
IFRS[edit]
On 6 September 2007,
the International Accounting
Standards Board issued a
revised IAS 1: Presentation of
Financial Statements, which is
effective for annual periods
A business entity adopting IFRS
must include:
a statement of
comprehensive income or
two separate statements
comprising:
1.an income
statement displaying
components of profit or loss and
2-a statement of
comprehensive
income that begins with profit
or loss (bottom line of the
income statement) and
displays the items of other
comprehensive income for the
reporting period. (IAS1.81)
All non-owner changes in
equity (i.e., comprehensive
income ) shall be presented in
either in the statement of
comprehensive income (or in
a separate income statement
and a statement of
comprehensive income).
Components of
comprehensive income may
not be presented in
the statement of changes in
equity.
Comprehensive income for a
period includes profit or loss
(net income) for that period
and other comprehensive
income recognised in that
period.
All items of income and
expense recognised in a
period must be included in
profit or loss unless a
Standard or an Interpretation
requires otherwise. (IAS 1.88)
Some IFRSs require or permit
that some components to be
excluded from profit or loss
and instead to be included in
other comprehensive income.
(IAS 1.89)
Items and disclosures
The statement of
comprehensive income should
include:[4] (IAS 1.82)
1.Revenue
2.Finance costs
(including interest expenses)
2.Share of the profit or loss
of associates and joint
ventures accounted for using
the equity method
3.Tax expense
4.A single amount comprising
the total of (1) the post-
tax profit or loss
of discontinued
operations and (2) the post-
tax gain or loss recognised on
the disposal of the assets or
disposal group(s) constituting
the discontinued operation
5.Profit or loss
6.Each component of other
comprehensive
income classified by nature
7.Share of the other
comprehensive income of
associates and joint ventures
accounted for using the equity
method
Total comprehensive income
The following items must also
be disclosed in the statement
of comprehensive income as
allocations for the period: (IAS
1.83)
-Profit or loss for the period
attributable to non-controlling
interests and owners of
the parent
-Total comprehensive income
attributable to non-controlling
interests and owners of the
parent
-No items may be presented in
the statement of
comprehensive income (or in
the income statement, if
separately presented) or in the
notes as extraordinary items.
The income statement is one
of three financial
statements that stock
investors need to become
familiar with (the other two
are balance sheet and cash
flow statement).
Understanding an income
statement is essential for
investors in order to
analyze the profitability and
future growth of a
company, which should play
a huge role in deciding
whether or not to invest in
it.
In the context of corporate
financial reporting, the
income statement
summarizes a
company's revenues (sales)
and expenses quarterly and
annually for its fiscal year.
Income statements come with
various monikers. The most
commonly used are
"statement of income,"
"statement of earnings,"
"statement of operations" and
"statement of operating
results." Many professionals
still use the term P&L, which
stands for profit and loss
statement, but this term is
seldom found in print these
day.
In addition, the terms
"profits," "earnings" and
"income" all mean the same
thing and are used
interchangeably.
Two basic formats for the
income statement are used in
financial reporting
presentationsthe multi-step
and the single-step. These
are illustrated below in two
simple examples.
n the multi-step income
statement, four measures of
profitability (*) are revealed at
four critical junctions in a
company's operations
gross, operating, pretax and
after tax.
In the single-step
presentation, the gross and
operating income figures are
not stated; nevertheless, they
can be calculated from the
data provided.
the single-step method, sales
minus materials and
production equal gross
income. And, by subtracting
marketing and administrative
and R&D expenses from
gross income, we get the
operating income figure. If
you are a DIY investor,
One last general
observation. Investors must
remind themselves that the
income
statement recognizes
revenues when they are
realizedso when goods
are shipped, services
rendered and expenses
incurred. With accrual
accounting, the flow
of accounting events through
the income statement doesn't
necessarily coincide with the
actual receipt
and disbursement of cash.
The income statement
measures profitability,
not cash flow.
Income Statement
Accounts (Multi-
Step Format)
Net Sales (a.k.a.
sales or revenue):
These terms refer to
the value of a
company's sales of
goods and services to
its customers. Even
though a
company's bottom
line (its net income)
gets most of the
attention from
investors, the top
line is where the
revenue or income
process begins. Also,
in the long run, profit
margins on a
company's existing
products tend to
eventually reach a
maximum that is
difficult on which to
improve. Thus,
companies typically
can grow no faster
than their revenues.
Cost of Sales (a.k.a.
cost of goods/products
sold (COGS), and cost
of services): For a
manufacturer, cost of
sales is the expense
incurred for labor, raw
materials, and
manufacturing
overhead used in the
production of goods.
While it may be stated
separately, depreciatio
n expense belongs in
the cost of sales. For
wholesalers and
retailers, the cost of
sales is essentially the
purchase cost of
merchandise used for
resale. For service-
related businesses,
 cost of sales
represents the cost of
services rendered or
cost of revenues. (To
learn more about
sales, read Measuring
Company
Efficiency, Inventory
Valuation For
Investors: FIFO And
LIFO and Great
Expectations:
Forecasting Sales
Growth.)
Gross Profit (a.k.a. detect signs, both
gross income or gross
margin): A
company's gross
profit does more than
simply represent the Operating Income:
difference between
net sales and the
cost of sales. Gross
profit provides the
resources to cover
all of the company's
other expenses.
Obviously, the
greater and more
stable a company's
gross margin, the
greater potential there
is for positive bottom
line (net income)
results.
Selling, General and operating level, which
Administrative
Expenses: Often
referred to as SG&A,
this account comprises
a company's
operational
expenses. Financial
analysts generally
assume that
management
exercises a great deal
of control over this
expense category. The
trend of SG&A
expenses, as a
percentage of sales, is
watched closely to
positive and negative,
of managerial
efficiency.
Deducting SG&A from
a company's gross
profit produces
operating income.
This figure
represents a
company's earnings
from its normal
operations before
any so-called non-
operating
income and/or costs
such as interest
expense, taxes
and special items.
Income at the
is viewed as more
reliable, is often
 used by financial as a more accurate
analysts rather than measure of corporate
net income as a profitability.
measure of
profitability. Income Taxes: As
stated, the income tax
Interest Expense: amount has not
This item reflects the actually been paid
costs of a company's it is an estimate, or
borrowings. an account that has
Sometimes companies been created to
record a net figure cover what a
here for interest company expects to
expense and interest pay.
income from invested
funds. Special Items or
Extraordinary
Pretax Income: Expenses: A variety
Another carefully of events can occasion
watched indicator of charges against
profitability, earnings income. They are
garnered before commonly identified
the income as restructuring
tax expense is an charges, unusual or
important bullet in nonrecurring items
the income and discontinued
statement. Numerous operations.
and diverse These write-offs are
techniques are supposed to be one-
available to time events. Investors
companies to avoid need to take these
and/or minimize special items into
taxes that affect their account when making
reported income. inter-annual profit
Because these comparisons because
actions are not part they can distort
of a company's evaluations.
business operations,
analysts may choose Net Income (a.k.a. net
to use pretax income profit or net earnings):
 This is the bottom line, as foreign currency
which is the most translations adjustm
commonly used ents, minimum
indicator of a pension liability
company's profitability. adjustments
Of course, if expenses and unrealized
exceed income, this gains/losses on
account caption will certain investments
read as a net loss. in debt and equity.
After the payment The investment
of preferred dividends, community continues
if any, net income to focus on the net
becomes part of a income figure. The
company's equity posit aforementioned
ion as retained adjustment items all
earnings. relate to volatile
Supplemental data is market and/or
also presented for net economic events that
income on the basis are out of the control
of shares of a company's
outstanding (basic) management. Their
and the potential impact is real when
conversion of stock they occur, but they
options, warrants etc. tend to even out over
(diluted). (To read an extended period of
more, see Evaluating time.
Retained Earnings:
What Gets Kept
Counts and Everythin
g You Need To Know
About Earnings.) What Is A Cash Flow Statement?
The CFS allows investors to understand how a
Comprehensive company's operations are running, where
Income: The concept its money is coming from, and how it is
of comprehensive being spent. Here you will learn how the CFS
income, which is is structured, and how to use it as part of your
relatively new (1998), analysis of a company.
takes into
consideration the The cash flow statement is distinct from the
effect of such items income statement and balance sheet
because it does not include the amount of
future incoming and outgoing cash that
has been recorded on credit.
therrefore, cash is not the same as net
income, which on the income statement and
balance sheet, includes cash sales and sales
made on credi
Cash flow is determined by looking at three
components by which cash enters and leaves
a company: core operations, investing and
financing,
Operations
the cash inflows and outflows caused by core
business operations, the operations
component of cash flow reflects how much
cash is generated from a company's products
or services. Generally, changes made in
cash, accounts
receivable, depreciation, inventory and accoun
ts payable are reflected in cash from
operations.
CF is calated by making certain adjustments
to net income by adding or subtracting
differences in revenue, expenses and
credit transactions (appearing on the
balance sheet and income statement)
resulting from transactions that occur from one
period to the nex. These adjustments are
made because non-cash items are
calculated into net income (income
statement) and
total assets and liabilities (balance sheet). So,
because not all transactions involve actual
cash items, many items have to be re-
evaluated when calculating cash flow from
operations.
The only time income from an asset is
accounted for in CFS calculations is when
the asset is sold.
in accounts receivable on the balance sheet
from one accounting period to the next must
also be reflected in cash flow. If accounts
receivable decreases, this implies that more
cash has entered the company from
customers paying off their credit accounts
- the amount by which AR has decreased
is then added to net sales.
An increase in inventory, on the other hand,
signals that a company has spent more
money to purchase more raw materials. If the
inventory was paid with cash, the increase in
the value of inventory is deducted from net
sales. A decrease in inventory would be
added to net sales. If inventory was purchased
on credit, an increase in accounts payable
would occur on the balance sheet, and the
amount of the increase from one year to the
other would be added to net sales.
The same logic holds true for taxes payable,
salaries payable and prepaid insurance. If
something has been paid off, then the
difference in the value owed from one year to
the next has to be subtracted from net income.
If there is an amount that is still owed, then
any differences will have to be added to net
earnings
Investing
Changes in equipment, assets, or investments
relate to cash from investing. Usually, cash
changes from investing are a "cash out" item,
because cash is used to buy new equipment,
buildings, or short-term assets such
as marketable securities. However, when a
company divests of an asset, the transaction
is considered "cash in" for calculating cash
from investing.
Financing
Changes in debt, loans or dividends are
accounted for in cash from financing. Changes
in cash from financing are "cash in" when
capital is raised, and they're "cash out" when
dividends are paid. Thus, if a company issues
a bond to the public, the company receives
cash financing; however, when interest is paid
to bondholders, the company is reducing its
cash.
Tying the CFS with the
Balance Sheet and Income
Statement
As we have already discussed, the cash flow
statement is derived from the income
statement and the balance sheet. Net
earnings from the income statement is the
figure from which the information on the CFS
is deduced. As for the balance sheet, the net
cash flow in the CFS from one year to the next
should equal the increase or decrease of cash
between the two consecutive balance sheets
that apply to the period that the cash flow
statement covers. (For example, if you are
calculating a cash flow for the year 2016, the
balance sheets from the years 2015 and 2016
should be used.)
A company can use a cash flow statement
to predict future cash flow, which helps
with matters in budgeting. For investors,
the cash flow reflects a
company's financial health: basically, the
more cash available for business operations,
the better. However, this is not a hard and fast
rule. Sometimes a negative cash flow results
from a company's growth strategy in the form
of expanding its operations.
By adjusting earnings, revenues, assets
and liabilities, the investor can get a very
clear picture of what some people consider
the most important aspect of a company - how
much cash it generates and, particularly, how
much of that cash stems from core operations.
What Cash Flow Doesn't Tell Us
or example, as we explained above, it doesn't
tell us the profit earned or lost during a
particular period: profitability is composed also
of things that are not cash based.
it doesn't tell the whole profitability story, cash
flow doesn't do a very good job of indicating
the overall financial well-being of the company.
Sure, the statement of cash flow indicates
what the company is doing with its cash and
where cash is being generated, but these do
not reflect the company's entire financial
condition. The cash flow statement does not
account for liabilities and assets, which are
recorded on the balance sheet.
Furthermore accounts
receivable and accounts payable, each of
which can be very large for a company, are
also not reflected in the cash flow statement
No matter how profitable a company may be,
if it doesn't have the cash to pay its bills, it will
be in serious trouble.
Remain diligent in your analysis of a
company's cash flow statement and you will
be well on your way to removing the risk of
one of your stocks falling victim to a cash flow
crunch.
Comparing The P/E, EPS And
Earnings Yield
The basic definition of a P/E ratio is stock
price / earnings per share (EPS). The fact that
the P/E measure is a ratio makes it
particularly apt for valuation purposes, but
it's a little difficult to use intuitively when
evaluating potential return, especially
among different investment types. This is
where earnings yield comes in.
Earnings Yield Defined
Earnings yield is defined as EPS / the stock
price (E/P). In other words, it is the
reciprocal of the P/E ratio.
Thus, Earnings Yield = EPS / Price = 1 /
(P/E Ratio), expressed as a %.
If Stock A is trading at $10 and its EPS for
the past year (or trailing 12 months,
abbreviated as ttm) was 50 cents, it has a
P/E of 20 (i.e. $10/50 cents) and an earnings
yield of 5% (50 cents/$10).
If Stock B is trading at $20 and its EPS (ttm)
was $2, it has a P/E of 10 and an earnings
yield of 10% ($2/$20).
ssuming that A and B are very similar
companies operating in the same sector, with
nearly identical capital structures, which one
do you think represents the better value? The
obvious answer is B. From a valuation
perspective, it has a much lower P/E. From an
earnings yield point of view, B has a yield of
10%, which means that every dollar invested
in the stock would generate EPS of 10 cents.
Stock A, on the other hand, only has a yield of
5%, which means that every dollar invested in
it would generate EPS of 5 cents.
The earnings yield makes it easier to
compare potential returns between, say, a
stock and a high-yield bond. Lets say an
investor with some risk appetite is trying to
decide between Stock B and a junk bond with
a 6% yield. Comparing Bs P/E of 10 and the
junk bonds 6% yield is akin to comparing
apples and oranges. But using Bs 10%
earnings yield makes it easier for the investor
to compare returns and decide whether the
yield differential of 4 percentage points
justifies the risk of investing in the stock rather
than the bond. Note that even if Stock B only
has a 4% dividend yield (more about this
later), the investor is more concerned about
total potential return than actual return.
EPS and P/E
EPS is the bottom-line measure of a
companys profitability, and it's basically
defined as net income divided by the number
of outstanding shares. Basic EPS has the
basic number of shares outstanding in the
denominator, while fully diluted EPS (FDEPS)
uses the number of fully diluted shares in the
denominator.
Likewise, P/E comes in two main forms:
Trailing P/E refers to the
price/earnings ratio based on EPS for
the trailing four quarters or 12 months
as noted earlier.
Forward P/E means the price/earnings
ratio based on future estimated EPS,
such as the current fiscal or calendar
year, or the next year.
The P/E ratio for a specific stock, while
useful enough on its own, is of even
greater utility when compared against
other parameters, such as:
Sector P/E: Comparing the stocks P/E
to those of other similar-sized companies
in its sector, as well as to the sectors
average P/E, will enable one to determine
whether the stock is trading at a
premium or discount valuation in relation
to its peers.
 Relative P/E: Comparing the stock's P/E
with its P/E range over a period of time
provides an indication of investor perception.
A stock may be trading at a much lower P/E
now than it did in the past because investors
perceive that its most rapid growth is behind it.
P/E to Earnings Growth (PEG Ratio):
The PEG ratio compares the P/E to future or
past earnings growth. A stock with a P/E of 10
and earnings growth of 10% has a PEG ratio
of 1, while one with a P/E of 10 and earnings
growth of 20% has a PEG ratio of 0.5.
According to the PEG ratio, the second
company is undervalued compared to the
first one.
Using Earnings Yield to Compute
Dividend Payout Ratio
Earnings Yield = EPS / Price = 1 / (P/E
Ratio),
ericeee RATIO: Es el dividendo por
accin /beneficio por accin. % de
benfiios por accin que es pagado en
dividnednos.
Parte que se dedica del beneficio neto a
retribuir al accionista va dividendos. Se
trata de un indicador de la poltica de
autofinanciacin y de reparto de
dividendo que tiene la empresa.
One issue that often arises with a stock that
pays a dividend is that of its payout ratio,
which in its most basic form is the ratio of
dividends paid as a percentage of EPS.
The payout ratio is an important indicator
of dividend sustainability.
If a LriceLe consistently pays out more in
dividends Lri it earns in net income, the
dividend may be in jeopardy (danger) at some
point.
While a less-stringent definition of the
payout ratio uses dividends paid as a
percentage of cash flow per share, for the
sake of simplicity, we define dividend payout
ratio in this section as: Dividends per Share
(DPS) / EPS.
He dividend yield is another measure
commonly used to gauge a stocks potential
return. A stock with a dividend yield of 4% and
\rice\e appreciation of 6% has a potential total
return of 10%.
Dividend Yield = Dividends per Share
(DPS) / Price
Since Dividend Payout Ratio = DPS / EPS,
dividing both the numerator and denominator
by \rice gives us:
Dividend Payout Ratio = (DPS/P) / (EPS/P)
= Dividend Yield / Earnings Yield
P/E vs. Earnings Yield
P/E=stock Price/earnigns per share
Earnings yiled=earongs per share/stock
Price=1/(P/E)
The P/Es pre-eminence as a valuation
measure is unlikely to be derailed anytime
soon by the earnings yield, which is not as
widely used. While the major advantage of the
earnings yield is that it enables an intuitive
comparison of potential returns to be made, it
has the following drawbacks:
Greater Degree of Uncertainty: The
return indicated by the earnings yield has
a much greater degree of uncertainty than
the return from a fixed-income instrument.
More Volatility: Since net income and
EPS can fluctuate significantly from one
year to the next, the earnings yield will
generally be more volatile than fixed-
income yields.
Indicative Return Only: The earnings yield
only indicates the approximate return based on
EPS; the actual return may diverge substantially
from the earnings yield, especially for stocks that
pay no dividends or small dividends.
P/E may be the established standard for
valuation purposes, but its reciprocal the
earnings yield is especially useful for
comparing potential returns across
different instruments. The earnings yield
also enables back-of the-envelope
calculations to be made for computing the
dividend payout ratio of a stock using widely
followed measures such as its dividend
yield and inverse P/E ratio.
Earnings Yield
Earnings yield are the earnings per share for the
most recent 12-month period divided by the
current market price per share. The earnings
yield (which is the inverse of the P/E ratio) shows
the percentage of each dollar invested in the
stock that was earned by the company. The
earnings yield is used by many investment
managers to determine optimal asset
allocations.
Earnings yield=earings per share frthw most
recent 12 month/current marke Price per
share
Money managers often compare the earnings
yield of a broad market index (such as the S&P
500) to prevailing interest rates, such as the
current 10-year Treasury yield. If the earnings
yield is less than the rate of the 10-year
Treasury yield, stocks as a whole may be
considered overvalued. If the earnings yield is
higher, stocks may
considered undervalued relative to bonds.
Economic theory suggests that investors in
equities should demand an extra risk
premium of several percentage points above
prevailing risk-free rates (such as T-bills) in
their earnings yield to compensate them for the
higher risk of owning stocks over bonds and
other asset classes.
Earnings Yield(E/P) vs. P/E
Ratio
Earnings yield as an investment evaluation metric
is not as widely used as its P/E ratio inverse in
stock valuation. Earnings yield can be useful
when concerned about the rate of return on
an investment. For equity investors, however,
earning periodic investment income may be
secondary to growing their investments' values
over time. This is a why investors may refer to
value-based investment metrics such as P/E ratio
more often than earnings yield when making
stock investment
Earnings Yield and Return
Metric
For investors looking to invest in stocks with
stable dividend income, earnings yield can offer
a direct look into the level of return such
dividend stocks may generate. In this case,
earnings yield is more of a return metric about
how much an investment can earn back for
investors, rather than a valuation metric about
how much the investment is valued in the
market by investors. However, a valuation
metric such as P/E ratio can affect a return
metric like earnings yield. An overvalued
investment can lower earnings yield and
conversely, an undervalued investment can
raise earnings yield.
Earnings Yield and Valuation
Metric
he inverse relationship between earnings yield
and P/E ratio seem to indicate that the more
valuable an investment is, the lower the
earnings yield may be, and the less valuable
an investment is, the higher the earnings
yield may be. In reality, however, investments
with strong valuations and high P/E ratios might
generate more earnings over time and
eventually boost up their earnings yield. On
the other hand, investments with weak
valuations and low P/E ratios might generate
less earnings over time and, in the end, drag
down their earnings yield.
Forward Price To Earnings -
Forward P/E
Forward price to earnings (forward P/E) is a
measure of the price-to-earnings (P/E) ratio using
forecasted earnings for the P/E calculation.
While the earnings used are just an estimate
and are not as reliable as current earnings
data, there is still benefit in estimated P/E
analysis. The forecasted earnings used in the
formula can either be for the next 12 months or
for the next full-year fiscal period.
There are two main ways to value a stock:
I)with earnings or II)with cash flow
Cash flows are generally discounted back to
a present value, while earnings are measured
in terms of relative price.
The most popular earnings valuation metric is
the P/E ratio, which is calculated using the
current stock price and historical earnings data.
Forward P/E is calculated using earnings
estimates rather than actual earnings.
he Price-to-Earnings Ratio
Analysts like to think of the P/E ratio as a price
tag on earnings. It is used to calculate a relative
value based on a company's level of earnings.
In theory, $1 of earnings at company A is
worth the same as $1 of earnings at company
B. If this is the case, both companies should
also be trading at the same price, but this is
rarely the case. If company A is trading for $5
and company B is trading for $10, it means
the market values company B's earnings at a
higher price. This may be a sign that
company B's earnings are overvalued. It could
also mean that company B deserves a premium
on the value of its earnings due to superior
management and a better business model.
Forward Price-to-Earnings
Ratio
Forward Price-to-Earnings
Ratio
When calculating the P/E ratio, analysts compare
today's price against earnings for the last 12
months, or the last fiscal year, but both are based
on historical prices. Analysts use earnings
estimates to determine what the relative value of
the company will be at a future level of earnings.
The forward P/E estimates the relative value of
the earnings. For example, if the current price of
company B is $10, and earnings are estimated
to double next year to $2, the forward P/E
ratio is 5x, or half the value of the company
when it made $1 in earnings. If the forward
P/E ratio is lower than the current P/E ratio, it
means analysts are expecting earnings to
increase; so now it is overvalued(sell) but int the
future will be undervalued(buy), if the forward P/E
is higher than the current P/E ratio, analysts
expect a decrease in earnings.
Bond Equity Earnings Yield
Ratio BEER
A metric used to evaluate the relationship
between bond yields and earnings yields in the
stock market. The Bond Equity Earnings Yield
Ratio
(BEER) has two parts =a benchmark bond
yield (such as five- or 10-year Treasuries)/ the
current earnings yield of a stock benchmark
(such as the S&P 500). it is the inverse of P/E
ratio
A BEER of 1 would indicate equal levels of
perceived risk in the bond market and the stock
market. Analysts often feel that BEER ratios
greater than 1 imply that equity markets are
overvalued, while numbers less than 1 mean
they are undervalued, or that prevailing bond
yields are not adequately pricing risk.
. If the BEER is above normal levels the
assumption is that the price of stocks will
decrease thus lowering the BEER.
Price-Earnings Ratio - P/E Ratio
The price-earnings ratio (P/E Ratio) is the ratio
for valuing a company that measures its
current share price relative to its per-share
earnings.
The price-earnings ratio can be calculated as:
=Market Value per Share / Earnings per Share
EPS is mos often derived from the last
four quarters. This form of the price-earnings
ratio is called trailing P/E, which may be
calculated by subtracting a companys share
value at the beginning of the 12-month period
from its value at the periods end, adjusting
for stock splits if there have been any.
-Sometimes, price-earnings can also be taken
from analysts estimates of earnings expected
during the next four quarters. This form of
price-earnings is also called projected
or forward P/E.
-A third, less common variation uses the sum
of the last two actual quarters and the
estimates of the next two quarters.
-The price-earnings ratio is also sometimes
known as the price multiple or the
earnings multiple.
This is why the P/E is sometimes referred to as
the multiple because it shows how much
investors are willing to pay per dollar of earnings.
If a company were currently trading at a multiple
(P/E) of 20, the interpretation is that an investor is
willing to pay $20 for $1 of current earnings.
In general, a high P/E suggests that investors
are expecting higher earnings growth in the
future compared to companies with a lower
P/E. A low P/E can indicate either that a
company may currently be undervalued or
that the company is doing exceptionally well
relative to its past trends. When a company has
no earnings or is posting losses, in both cases
P/E will be expressed as N/A.
The price-earnings ratio can also be seen as a
means of standardizing the value of one
dollar of earnings throughout the stock
market. In theory, by taking the median of P/E
ratios over a period of several years, one
could formulate something of a standardized
P/E ratio, which could then be seen as a
benchmark and used to indicate whether or not
a stock is worth buying.
Limitations of 'Price-Earnings Ratio - P/E
Ratio'
the price-earnings ratio comes with a few
important limitations that are important to
take into account, one single metric that will
provide complete insight into an investment
decision, which is virtually never the case.
One primary limitation of using P/E ratios
emerges when comparing P/E ratios of
different companies. Valuations and growth
rates of companies may often vary wildly
between sectors due both to the differing
ways companies earn money and to the
differing timelines during which companies
earn that money.
As such, one should only use P/E as a
comparative tool when considering
companies within the same sector, as this
kind of comparison is the only kind that will
yield productive insight. Comparing the P/E
ratios of a telecommunications company and
an energy company, for example, may lead
one to believe that one is clearly the superior
investment, but this is not a reliable assumption.
An individual companys P/E ratio is much
more meaningful when taken alongside P/E
ratios of other companies within the same
sector. For example, an energy company may
have a high P/E ratio, but this may reflect a
trend within the sector rather than one merely
within the individual company. An individual
companys high P/E ratio, for example, would
be less cause for concern when the entire
sector has high P/E ratios.
Moreover, because a companys debt can
affect both the prices of shares and the
companys earnings, leverage can skew P/E
ratios as well. For example, suppose there are
two similar companies that differ primarily in
the amount of debt they take on. The one with
more debt will likely have a lower P/E value
than the one with less debt. However, if
business is good, the one with more debt
stands to see higher earnings because of
the risks it has taken.
Another important limitation of price-earnings
ratios is one that lies within the formula for
calculating P/E itself. Accurate and unbiased
presentations of P/E ratios rely on accurate
inputs of the market value of shares and of
accurate earnings per share estimates. While
the market determines the value of shares and,
as such, that information is available from a
wide variety of reliable sources, this is less so
for earnings, which are often reported by
companies themselves and thus are more
easily manipulated. Since earnings are an
important input in calculating P/E, adjusting
them can affect P/E as well. (See also, How
can the P/E ratio mislead investors?)
Things to Remember
Generally a high P/E ratio means that
investors are anticipating higher
growth in the future.
The average market P/E ratio is 20-25
times earnings.
The P/E ratio can use estimated
earnings to get the forward looking P/E
ratio.
Companies that are losing money do
not have a P/E ratio.
Trailing Price-To-Earnings - Trailing
P/E
Trailing price-to-earnings (P/E) is calculated by
taking the current stock price and dividing it by
the trailing earnings per share (EPS) for the
past 12 months. This measure differs
from forward P/E, which uses
earnings estimates for the next four quarters.
As a result, forward P/E can sometimes be
more relevant to investors when evaluating a
company.
The P/E ratio is calculated by dividing a
company's stock price by its earnings from the
most recent fiscal year. The earnings for the
most recent fiscal year can be found in
the annual report on the income statement. At
the bottom of the income statement is a total
EPS for the firm's entire fiscal year. Divide
the current price by this number for the traditional
P/E ratio. For example, a company with a stock
price of $50 and EPS of $2 has a P/E ratio of
25x, read 25 times. This means that the
company's stock is trading at 25x its EPS.
Why Do Analysts Use P/E
Analysts like the P/E ratio because it places a
relative price tag on earnings. This relative
price tag can be used to look for bargains or
to determine when a stock is too expensive.
Some companies
-deserve a higher price tag because they've
been around longer and have
deeper economic moats,
but some companies are simply overpriced.
-Likewise, some firms deserve a lower price
tag because they have an unproven track
record, while others are underpriced,
representing a great bargain.
Trailing P/E helps analysts match time
periods for a more accurate and up-to-date
measure of relative value.
Trailing Price-To-Earnings
A disadvantage of the P/E ratio is that stock
prices are constantly moving, while earnings
remain fixed. Analysts attempt to deal with this
issue by using the trailing P/E ratio, which
uses earnings from the most recent four
quarters rather than earnings from the end of
the last fiscal year.
Using the same example, if the company's stock
price falls to $40 midway through the year, the
new P/E ratio is 20x, which means the stock's
price is now trading at only 20x its earnings.
Earnings have not changed, but the stock's
price dropped. Earnings for the last two
quarters may have also dropped. In this case,
analysts can substitute the first two quarters
of the fiscal year calculation with the most
recent two quarters for a trailing P/E ratio. If
earnings in the first half of the year, represented
by the most recent two quarters, are trending
lower, the P/E ratio will be higher than 20x. This
tells analysts that the stock may actually
be overvalued at the current price given its
declining level of earnings.
Price/Earnings To Growth -
PEG Ratio
The price/earnings to growth ratio (PEG ratio)
is a stock's price-to-earnings (P/E) ratio / the
growth rate of its earnings for a specified time
period. The PEG ratio is used to determine a
stock's value while taking the company's
earnings growth into account, and is
considered to provide a more complete picture
than the P/E ratio.
While a low P/E ratio may make a stock look
like a good buy, factoring in the company's
growth rate to get the stock's PEG ratio can
tell a different story. The lower the PEG ratio,
the more the stock may be undervalued given
its earnings performance. The degree to
which a PEG ratio value indicates an over or
underpriced stock varies by industry and by
company type, though a broad rule of thumb is
that a PEG ratio below one is desirable. Also,
the accuracy of the PEG ratio depends on the
inputs used. Using historical growth rates, for
example, may provide an inaccurate PEG ratio
if future growth rates are expected to deviate from
historical growth rates. To distinguish between
calculation methods using future growth and
historical growth, the terms "forward PEG"
and "trailing PEG" are sometimes used.
Franchise Factor
The measurement of the impact on a
company's price-earnings (P/E) ratio per unit
growth in new investment.
FF=P/E ratio/ growth in investmemnt.
For example, a franchise factor of 3 would
indicate that the P/E ratio of a company would
increase by three units for every unit of
growth in the company's book value.
The franchise factor can be calculated as the
product of annual investment returns in
excess of market returns and the duration of
the returns. A P/E ratio will not be elevated with
a high franchise factor alone.
A company with a high franchise factor will
have exceptionally high P/E ratios in
comparison to its book value. This comes from
the ability to continually capitalize on basic
strengths, rather than the financial strength of
the business. Because this is the case in many
franchises, the term "franchise factor" was
developed.
Franchise P/E
he expected value of new business
opportunities available to a business.
The franchise approach to evaluating a company
breaks down the company's observed P/E into
two primary components: the P/E coming from
the company's business activities (base P/E)
and the franchise P/E. In this sense, the
franchise P/E = observed P/E - base P/E. It is a
function of the rate of return on a business
opportunity (the franchise factor) relative to
the size of the opportunity (the growth factor).
Franchise Factor (FF) x Growth Factor (G) =
(1/k - 1/ROE) x g/(k-g), where:
BREAKING DOWN 'Franchise
P/E'
The major factors determining the franchise
P/E are the differences between the return on
the new opportunity and the cost of equity.
Investors should consider the growth rate and
how long growth can be sustained, as well as
the feasibility of the estimates (after all, they are
expectations and not reality).
P/E 30 Ratio
he price-to-earnings (P/E) ratio is
the valuation ratio of a company's market
value per share divided by a
company's earnings per share (EPS). A P/E
ratio of 30 means that a company's stock price
is trading at 30 times the company's earnings
per share.
A P/E of 30 is high by historical stock
market standards. This type of valuation is
usually placed on only the fastest-growing
companies by investors in the company's
early stages of growth. Once a company
becomes more mature, it will grow more
slowly and the P/E tends to decline.
Overvalued
An overvalued stock has a current price that is
not justified by its earnings outlook or
price/earnings (P/E) ratio, so it is expected to
drop in price. Overvaluation may result from
an emotional buying spurt, which inflates the
stock's market price, or from a deterioration in a
company's financial strength. Potential
investors do not want to overpay for a stock.
A small group of staunch efficient market
theorists believe the market is perfectly
efficient. They believe that fundamental
analysis of a stock is a wasted exercise
because the stock market is all-knowing; as
such, stocks are never undervalued or
overvalued.
Fundamental analysts think otherwise. For them,
there are always opportunities to find
undervalued and overvalued stocks, because
the market is as irrational as its participants.
Overvalued
Fundamental analysts look for two conditions
in stock market analysis: stocks that are
undervalued and stocks that are overvalued.
Undervalued stocks are offered to investors at
a discount, but overvalued stocks are
trading at a premium. Overvalued stocks are
ideal for investors looking to short a position;
that is, selling shares with the intention of
buying them when the price is in line with the
market. Overvalued stocks may also be
legitimately trading at a premium due to
brand, goodwill, better management or other
factors that increase the value of one company's
earnings over another.
How to Find Overvalued Stocks
The most common way to determine if a stock is
overvalued uses relative earnings. Relative
earnings analysis involves comparing
earnings to some market value, such as price.
The most popular ratio is the P/E ratio, which
compares a company's earnings to its stock
price. A company that's trading at a price 50
times its earnings is considered to be trading
at a much higher multiple than a company
trading for 10 times its earnings. In fact, the
company trading for 50 times its earnings is
most likely to be overvalued.
Analysts looking for stocks to short are looking
for overvalued companies with high P/E
ratios, especially when compared against
other companies in the same industry or peer
group. For example, assume a company with a
stock price of $100, and an earnings per
share (EPS) of $2, has a P/E ratio, calculated as
price divided by earnings, of $100 divided by $2,
or 50 times. If that same company has a bumper
year and makes $10 in EPS, the new P/E ratio is
$100 divided by $10, or 10 times. The company
is considered to be overvalued if earnings are
$2 per share, but undervalued if earnings are
$10 per share.
Multiple
A multiple measures some aspect of a
company's financial well-being, determined
by dividing one metric by another metric. The
metric in the numerator is typically larger than the
one in the denominator.
For example, a multiple can be used to show
how much investors are willing to pay per
dollar of earnings, as computed by the price-
to-earnings (P/E) ratio. Assume you are
analyzing a stock with $2 of earnings per
share (EPS) that is trading at $20. This stock has
a P/E ratio of 10. This means investors are
willing to pay a multiple of 10 times the
current EPS for the stock.
Calculated as:
In the world of stock valuation, there are two
different valuation methods: one is based
on cash flow, and the other is based on a
multiple of some performance measure, such
as the earnings or sales. Valuation based on
cash flow is considered to be an intrinsic
valuation, and valuation based on a multiple
is considered to be relative, because the
multiple is relative to some performance
measure.
Commonly Used Multiples
The most common multiple used in the valuation
of stocks is the P/E multiple. It is used to
compare a company's market value with its
earnings. A company with a price or market value
that is high compared to its level of earnings has
a high P/E multiple. A company with a low price
compared to its level of earnings has a low P/E
multiple. A P/E of 5x means a companys stock is
trading at a multiple of five times its earnings. A
P/E of 10x means a company is trading at a
multiple that is equal to 10 times earnings. A
company with a high P/E is considered to
be overvalued. Likewise, a company with a low
P/E is considered to be undervalued.
Other commonly used multiples include
the enterprise value (EV) to earnings before
interest, taxes, depreciation
and amortization (EBITDA) multiple, also referred
to EV/EBITDA. It is used to measure the cash
flow available to the firm. EV to earnings before
interest and taxes (EBIT), also referred to as
EV/EBIT, is used for less capital-intensive
companies with a small depreciation and
amortization expense. The EV to sales ratio, also
referred to as EV/Sales, is a multiple that
companies with negative earnings often use. All
multiples act as a single number
that analysts can multiply by some financial
metric to determine the relative value.
Rule Of 18
A rule whereby the sum of the inflation rate and
the P/E ratio of the Dow Jones Industrial Average
is an indicator of the direction of the stock
market. If the total is above 18, stocks are
supposed to decrease. If the total is under 18,
then the stock market is expected to increase.
BREAKING DOWN 'Rule Of 18'
For example, if the P/E ratio for the Dow were 14
and the annual inflation rate were 3%, their sum
would equal 17. This number would indicate that
the stock market will increase.
Trailing Twelve Months TTM
Trailing 12 months (TTM) is the timeframe of the
past 12 months used for reporting financial
figures. A company's trailing 12 months represent
its financial performance for a 12-month period,
but typically not at its fiscal year end. Since
quarterly reports rarely report how the company
has done in the prior 12 months, TTM tends to be
calculated manually, by adding together the last
four quarterly values.
BREAKING DOWN 'Trailing
Twelve Months - TTM'
TTM figures can also be used to
calculate financial ratios. For example, the
price/earnings ratio is often quoted as P/E (ttm),
meaning they're using the EPS from the prior 12
months.
Much of fundamental analysis is about
comparing a measurement against a previous
time frame to see how much it grew or declined.
A company with $1 billion in revenue is
interesting. A company that grew revenues from
$.5 billion to $1 billion in one year is even more
interesting.
The TTM Compromise
Some analysts report earnings every quarter,
while others report earnings once a year. What
about measures that change on a daily basis,
such as stock price? It's easy to compare the
price of a stock today against the price of a stock
tomorrow or a year from now, but what if you
want to compare today's stock price to a measure
that's only reported annually and updated once a
quarter, such as the price-to-earnings ratio? In
this case, analysts can use the last trailing 12
months, or TTM, for a more relevant measure.
The annual time period is not current, and the
quarterly time period may skew performance.
Twelve months, and specifically the last 12
months, provides investors with a compromise
that is both current and seasonally adjusted.
Where to Find the TTM
For line items on the balance sheet, such as
cash, property and liabilities, the 12-month
measure is taken from the most recent balance
sheet, which is updated quarterly. Some analysts
take an average of the first quarter and the last
quarter. For line items on the income statement,
such as revenues, expenses and net income,
analysts take the four most recent quarters. Line
items on the cash flow statement, such as
working capital, capital expenditures and
dividend payments, should be treated based on
the feeding financial statement. For example,
working capital is comprised of balance sheet line
items, which are averaged.
However, depreciation is deducted from income
on a quarterly basis, so analysts look at the last
four quarters as reported on the income
statement.
Earnings Per Share EPS
Earnings per share (EPS) is the portion of a
company's profit allocated to each outstanding
share of common stock. Earnings per share
serves as an indicator of a company's
profitability.
Calculated as:
When calculating, it is more accurate to use
a weighted average number of shares
outstanding over the reporting term, because the
number of shares outstanding can change over
time. However, data sources sometimes simplify
the calculation by using the number of shares
outstanding at the end of the period.
Diluted EPS expands on basic EPS by including
the shares
of convertibles or warrants outstanding in
the outstanding shares number.
BREAKING DOWN 'Earnings
Per Share - EPS'
Earnings per share is generally considered to be
the single most important variable in determining
a share's price. It is also a major component
used to calculate the price-to-
earnings valuation ratio.
For example, assume that a company has a net
income of $25 million. If the company pays out $1
million in preferred dividends and has 10 million
shares for half of the year and 15 million shares
for the other half, the EPS would be $1.92
(24/12.5). First, the $1 million is deducted from
the net income to get $24 million, then a
weighted average is taken to find the number of
shares outstanding (0.5 x 10M+ 0.5 x 15M =
12.5M).
An important aspect of EPS that's often ignored
is the capital that is required to generate the
earnings (net income) in the calculation. Two
companies could generate the same EPS
number, but one could do so with less equity
(investment) - that company would be more
efficient at using its capital to generate income
and, all other things being equal, would be a
"better" company. Investors also need to be
aware of earnings manipulation that will affect the
quality of the earnings number. It is important not
to rely on any one financial measure, but to use it
in conjunction with statement analysis and other
measure
Fully Diluted Shares
Fully diluted shares are the total number of
shares that would be outstanding if all possible
sources of conversion, such as convertible
bonds and stock options, are exercised. This
number of shares is important for a companys
earnings per share (EPS) calculation, because
using fully diluted shares increases the number of
shares used in the EPS calculation and reduces
the dollars earned per share of common stock.
EPS is a calculation of the dollar amount of
earnings a firm generates per share of common
stock outstanding, and analysts consider this
ratio to be a key indicator of company value
EPS is defined as (net income preferred
dividends) / (weighted average common shares
outstanding). Any earnings paid to preferred
shareholders as a cash dividend are subtracted
from net income, because the ratio applies only
to common shareholders. Weighted average
common shares is the (beginning period balance
+ ending period balance) / 2. If a business can
generate more earnings per common share, the
company is considered to be more valuable and
the share price may increase.
Assume, for example, that ABC Corporation
generates $10 million in net income and pays all
preferred shareholders a total of $2 million in
dividends, so that the net income available to all
common shareholders is $8 million. If the firms
weighted average common shares outstanding
total 1 million, the EPS is $8 per share. The $8
EPS is considered basic EPS, because the total
is not adjusted for dilution.
Factoring in Fully Diluted
Shares
Full dilution means that every security that can be
converted into common shares is converted,
which means that there are fewer earnings
available per share of common stock. Since EPS
is a key measure of a companys value, its
important for an investor to review EPS. Several
types of securities are converted into common
stock, including a convertible bond, convertible
preferred stock, stock options, rights and
warrants.
As an example, assume that ABC issues 100,000
shares in stock options to company executives to
reward them for reaching a profit goal. The firm
also has a convertible bond outstanding that
allows the bondholders to convert into a total of
200,000 shares of common stock, and ABC has
convertible preferred stock outstanding, and
those shares can be converted into 200,000
shares of common stock. Full dilution assumes
that all of the 500,000 in additional common stock
shares are issued, which increases the common
shares outstanding to 1.5 million. Using the same
$8 million in earnings to common shareholders,
fully diluted EPS is ($8 million / 1.5 million
shares), or $5.33 per share, which is lower than
the basic EPS of $8 per share.
Basic Earnings Per Share
Basic earnings per share is a rough
measurement of the amount of a company's
profit that can be allocated to one share of its
stock. Basic earnings per share (EPS) do not
factor in the dilutive effects of convertible
securities. Basic EPS is calculated as follows:
Basic EPS = (net income preferred
dividends) / weighted average number of
common shares outstanding
For companies that have a complex capital
structure (that is, they have issued potentially
dilutive securities), diluted EPS is considered to
be a more precise metric than basic EPS. Diluted
EPS takes into account all of the outstanding
dilutive securities that could potentially be
exercised (such as stock options and convertible
preferred stock) and shows how such an action
would affect earnings per share. If a company
has a simple capital structure, meaning that it has
not issued any potentially dilutive securities, then
basic EPS can be a useful metric on its own.
Companies with a complex capital structure must
report both basic EPS and diluted EPS to provide
a more accurate picture of their earnings per
share; basic EPS will always be the higher of the
two. If the company has a simple capital
structure, it only needs to report basic EPS.
Impact of Basic Earnings Per
Share
Stocks trade on multiples of earnings per share,
so a rise in basic EPS can cause a stock's price
to appreciate in line with the company's
increasing earnings on a per share basis.
Increasing basic EPS, however, does not mean
the company is generating greater earnings on a
gross basis. Companies can buy back shares,
decreasing their share count as a result and
spread net income less preferred dividends over
fewer common shares. Basic EPS could increase
even if absolute earnings decrease with a falling
common share count. Another consideration for
basic EPS is its deviation from diluted EPS; if the
two EPS measures are increasingly different, it
may show that there is a high potential for current
common shareholders to be diluted in the future.
Normal Market Size
A share classification structure based on the
number of shares outstanding. This determines
the number of shares that a market maker can
trade at the quoted price.
Buying or selling in amounts above the set
number of shares requires price negotiation with
the market maker. The Normal Market Size
system reduces the effect a market maker's
trading activity may have on the share price of a
stock that has shares outstanding in the low
thousands.
Options can fit a range of investing goals
whether it's maximizing your exposure or
helping to minimize your risk. If you want
to learn everything you need to know about
trading them, then sign up for our free 8-
week email course. Twice a week you'll
receive an email that will take you from not
knowing what an option is, to how you can
trade them within your brokerage account.
So sign up for free and start learning how
you can add options to your investing
toolkit.
Issued Shares
ssued shares are the authorized shares sold to
and held by the shareholders of a company,
regardless of whether they are
insiders, institutional investors or the general
public, as shown in the companys annual report.
Issued shares include the stock a
company sells publicly to generate capital and
the stock given to insiders as part of their
compensation packages. Unlike shares held
as treasury stock, shares that have been retired
are not included in this figure.
BREAKING DOWN 'Issued
Shares'
A company issues a share only once; after that,
the investor may sell it to another investor. When
companies buy back their own shares, the shares
remain listed as issued because the company
may resell them. For a small, closely held
corporation, the original owners may have all
issued shares.
Recording Issued Shares
The number of issued shares is recorded on a
companys balance sheet as capital stock.
Shares outstanding are listed on the companys
quarterly filings with the Securities and Exchange
Commission (SEC). The number of outstanding
shares is also found in the capital section of a
companys annual report.
Importance of Issued Shares
Issued shares are included when calculating
market capitalization, or issued shares multiplied
by current share price, and earnings per share
(EPS), or issued shares divided by earnings.
Both numbers help investors measure a
companys value and performance.
Comparing Authorized and
Issued Shares
Authorized shares are the shares a companys
founders approved in their corporate filing
paperwork before startup. Issued shares are the
shares the owners decided to exchange for the
cash, assets or other value given for founding the
company. This is called capitalizing the
corporation.
Issued Shares and Ownership
Ownership may be measured by which investors
were issued shares at a companys startup.
Ownership may also be measured by issued and
outstanding shares along with those that may
become issued if all authorized stock options are
exercised, called the fully diluted calculation. In
addition, ownership may be measured by using
issued and authorized stock as a forecast of the
position shareholders may be in at a future date,
called the working model calculation. All board
members must use the same calculation when
making decisions or plans for the business.
For example, if a startup issues 10 million shares
of 20 million authorized shares to an owner, and
the owners shares are the only ones issued, he
owns 100% of the corporation. Boards typically
use the fully diluted or working model calculation
for planning and projecting. For example, if the
board believes it may issue 2 million additional
shares to an investor and offers 3 million shares
as stock options to high-performing employees, it
may offer the founders additional stock options so
they do not significantly dilute their ownership
percentage.
Capitalization-Weighted Index
A capitalization-weighted index is a type
of market index with individual components that
are weighted according to their total market
capitalization. The larger components carry
higher percentage weightings, while the smaller
components in the index have lower weights.
This type of index is also known as a market
value-weighted index.
Most of the broadly used market indexes today
are cap-weighted indexes, such as the Standard
and Poor's (S&P) 500 Index,
the Nasdaq Composite Index, the Wilshire 5000
Total Market Index, the Hang Seng Index and the
MSCI EAFE Index. In a cap-weighted index, large
price moves in the largest components can have
a dramatic effect on the value of the index. Some
investors feel that this overweighting toward the
larger companies gives a distorted view of the
market, but the fact that the largest companies
also have the largest shareholder bases makes
the case for having the higher relevancy in the
index.
Capitalization-Weighted Index
Calculation Example
To find the value of a cap-weighted index, an
analyst should multiply each constituent's market
price by its total outstanding shares to arrive at
the total market value. Then, the proportion of
this value to the overall total market value of all
the index components gives the weight of the
company in the index. For example, consider the
following five companies:
Company A: 1 million shares outstanding, current
price per share equals $45
Company B: 300,000 shares outstanding, current
price per share equals $125
Company C: 500,000 shares outstanding, current
price per share equals $60
Company D: 1.5 million shares outstanding,
current price per share equals $75
Company E: 1.5 million shares outstanding,
current price per share equals $5
The total market value of each company would
be calculated as:
Company A market value = (1,000,000 x $45) =
$45,000,000
Company B market value = (300,000 x $125) =
$37,500,000
Company C market value = (500,000 x $60) =
$30,000,000
Company D market value = (1,500,000 x $75) =
$112,500,000
Company E market value = (1,500,000 x $5) =
$7,500,000
This means that the entire market value of all the
index components equals $232.5 million, giving
Company A a weight of 19.4%, Company B a
weight of 16.1%, Company C a weight of 12.9%,
Company D a weight of 48.4% and Company E a
weight of 3.2%. Even though the final two
companies have equal amounts of shares
outstanding, they are actually the highest and
lowest weighted companies in the index because
of the effects of their prices on their individual
market values.
In practice, an index divisor is calculated to make
reporting of the index level easier and more
manageable. In this example, on day one of the
index, a likely index divisor would be $232,500.
This would give the index an initial value of
$232,500,000 / $232,500 = 1,000.
Large Cap - Big Cap
Large cap (sometimes "big cap") refers to a
company with a market capitalization value of
more than $5 billion. Large cap is a shortened
version of the term "large market capitalization."
Market capitalization is calculated by multiplying
the number of a company's shares outstanding
by its stock price per share. The dollar amounts
used for the classifications "large cap," mid cap"
or "small cap" are only approximations that
change over time.
Investors like to diversify their portfolios by
investing in companies in different industries and
at varying levels of assets, revenue and market
size. A company's share price tells you little
about how big it is. A company with a market
price of $100 can be much smaller than a
company with a market price of $10 depending
on the number of shares it has outstanding in the
market.
Market capitalization describes the market size of
a company. While market capitalization provides
no information about the size of the company in
terms of assets or revenue, it does provide
information about the company's market depth.
Market capitalization is calculated by multiplying
the number of shares outstanding by the share
price of the company's stock. The number of
shares outstanding is reported on a quarterly
basis, but the price of the stock can change from
minute to minute. The value of market
capitalization is as fluid as the market price. For
example, a company with 10 billion shares
outstanding trading at a price of $10 per share
has a market capitalization of $100 billion.
Likewise, a company with 100 billion shares
outstanding, and trading at a price of $1, also has
a market capitalization of $100 billion.
In general, stocks are lumped into three
categories of capitalization: large cap, mid cap
and small cap. A large-cap company has a
market capitalization over $5 billion. A mid-cap
company has a market capitalization between $1
billion and $5 billion, and a small-cap company
has less than $1 billion in market capitalization. In
general, small caps also have lower trading
liquidity, less access to the capital markets and
less experience, and there's less information
available about small caps than large caps.
Due to their size, large-cap stocks are generally
believed to be safer, but they may not offer the
same opportunities for growth as small-cap and
mid-cap stocks. Financial advisors suggest
diversifying an investment portfolio by including
small-cap, mid-cap and large-cap stocks,
especially for investors with long-term investment
horizons.
All-Cap Fund
A stock mutual fund that invests
in equity securities without regard to whether a
company is characterized as small, medium or
large.
The term "cap" is shorthand for capitalization.
The investment community measures a
company's size by its market capitalization, which
is calculated by multiplying the number of a
company's outstanding shares by its current
stock price.
Mid-Cap Fund
A mid-cap fund is a type of stock fund that
invests in mid-sized companies. A company's
size is determined by its market capitalization,
with mid-sized firms generally ranging from $2
billion to $10 billion in market cap.
Most stocks held in a mid-cap fund are firms with
established businesses that are still considered
developing companies. These funds tend to offer
more growth than large-cap stocks and
less volatility than the small-cap segment.
The size restrictions for a mid-cap
stock fluctuates between funds. The range of $2
billion to $10 billion is only an approximation, and
it can change over time.
The 5 Types Of Earnings Per Share
Writer Gertrude Stein once said, "A rose is a rose
is a rose," but the same cannot be said
about earnings per share (EPS).
While the math may be simple, there are many
varieties of EPS being used these days and
investors must understand what each one
represents, if they're to make informed
investment decisions. For example, the EPS
announced by a company may differ significantly
from what is reported in the financial
statements and in the headlines. As a result, a
stock may appear over or under-valued
depending on the EPS being used. This article
will define some of the varieties of EPS and
discuss their pros and cons.
By definition, EPS is net income divided by the
number of shares outstanding, however, both the
numerator and denominator can change
depending on how you define "earnings" and
"shares outstanding." There are numerous ways
to define earnings, so let's start with shares
outstanding.
Shares Outstanding
Shares outstanding can be classified as either
primary, or basic, (primary EPS) or fully diluted
(diluted EPS). Primary EPS is calculated using
the number of shares that have been issued and
held by investors. These are the shares that are
currently in the market and can be traded.
Diluted EPS entails a complex calculation that
determines how many shares would be
outstanding if all exercisable warrants, options,
etc. were converted into shares at a point in time,
generally the end of a quarter. Diluted EPS is
preferred, because it is a more conservative
number that calculates EPS, as if all possible
shares were issued and outstanding. The number
of diluted shares can change as share
prices fluctuate (as options fall into/out of the
money), but generally the Street assumes the
number is fixed as stated in the 10-Q or 10-K.
Companies report both primary and diluted EPS
and the focus is generally on diluted EPS, but
investors should not assume this is always the
case. Sometimes, diluted and primary EPS are
the same, because the company does not have
any "in-the-money" options, warrants
or convertible bonds outstanding. Companies
can discuss either, so investors need to be sure
which is being used. (For more insight,
see Getting The Real Earnings.)
Earnings
As a general rule, EPS can be whatever the
company wants it to be, depending on
assumptions and accounting policies. Corporate
spin doctors focus media attention on the number
the company wants in the news, which may or
may not be the EPS reported in documents filed
with the Securities & Exchange Commission
(SEC). Based on a set of assumptions, a
company can report a high EPS, which reduces
the P/E multiple and makes the stock
look undervalued. The EPS reported in the 10-Q,
however, can result in a much lower EPS and
an overvalued stock on a P/E basis. This is why it
is critical for investors to read carefully and know
what type of earnings is being used in the EPS
calculation.
There are five types of EPS to be defined in the
context of the type of "earnings" being used:
Reported EPS (or GAAP EPS)
We define reported EPS as the number derived
from generally accepted accounting
principles (GAAP), which are reported in SEC
filings. The company derives these earnings
according to the accounting guidelines used. A
company's reported earnings can be distorted by
GAAP. For example, a one-time gain from the
sale of machinery or a subsidiary could be
considered as operating income under GAAP
and cause EPS to spike. Also, a company could
classify a large lump of normal operating
expenses as an "unusual charge," which can
boost EPS because the "unusual charge" is
excluded from calculations. Investors need to
read the footnotes in order to decide what factors
should be included in "normal" earnings and
make adjustments in their own calculations. (To
learn more about what can be found in the
footnotes, read Footnotes: Start Reading The
Fine Print.
Ongoing EPS
Ongoing EPS is calculated based upon
normalized, or ongoing, net income and excludes
anything that is an unusual one-time event. The
goal is to find the stream of earnings from core
operations, which can be used to forecast future
EPS. This can mean excluding a large one-time
gain from the sale of equipment, as well as an
unusual expense. Attempts to determine an EPS
using this methodology is also called "pro forma"
EPS.
Pro Forma EPS
The words "pro forma" indicate that assumptions
were used to derive whatever number is being
discussed. Different from reported EPS, pro
forma EPS generally excludes some expenses or
income that were used in calculating reported
earnings. For example, if a company sells a large
division, it could, in reporting historical results,
exclude the expenses and revenues associated
with that unit. This allows for more of an "apples-
to-apples" comparison.
Another example of pro forma is a company
choosing to exclude some expenses, because
management feels that the expenses are non-
recurring and distort the company's "true"
earnings. Non-recurring expenses, however,
seem to appear with increasing regularity these
days. This raises questions as to whether
management knows what it's doing, or is trying to
build a "rainy day fund" to smooth EPS.
Headline EPS
The headline EPS is the EPS number that is
highlighted in the company's press release and
picked up in the media. Sometimes it is the pro
forma number, but it could also be an EPS
number that has been calculated by the analyst
or pundit that is discussing the company.
Generally, sound bites do not provide enough
information to determine which EPS number is
being used. (For more on how companies can
skew their results, read 5 Tricks Companies Use
During Earnings Season.)
Cash EPS
Cash EPS is operating cash flow (not EBITDA)
divided by diluted shares outstanding. Generally,
cash EPS is more important than other EPS
numbers, because it is a "purer" number. Cash
EPS is better because operating cash flow
cannot be manipulated as easily as net income
and represents real cash earned, calculated by
including changes in key asset categories, such
as receivables and inventories. For example, a
company with reported EPS of 50 cents and cash
EPS of $1 is preferable to a firm with reported
EPS of $1 and cash EPS of 50 cents. Although
there are many factors to consider in evaluating
these two hypothetical stocks, the company with
cash is generally in better financial shape.
Other EPS numbers have overshadowed cash
EPS, but we expect it to get more attention
because of the new GAAP rule (FAS 142), which
allows companies to stop amortizing goodwill.
Companies may start talking about "cash EPS" in
order to differentiate between pre-FAS 142 and
post-FAS 142 results, however, this version of
"cash EPS" is more like EBITDA per share and
does not factor in changes in receivables and
inventory. Consequently, it may not be as good
as operating-cash-flow EPS, but is better in
certain cases than other forms of EPS.
The Bottom Line
There are many types of EPS being used and
investors need to know what the EPS numbers
they see represent and determine whether they
are a good representation of a company's
earnings. A stock may look like a great value
because it has a low P/E, but that ratio may be
based on assumptions which, upon further
research, you might not agree with.
What is the difference between
dividend yield and dividend
payout ratio?
The dividend yield and dividend payout ratio are
two valuation ratios investors and analysts use to
evaluate companies as investments for dividend
income. The dividend yield shows the annual
return per share owned that an investor realizes
from cash dividend payments, or the dividend
investment return per dollar invested. It is
expressed as a percentage and calculated as:
Dividend yield = annual dividends per share /
price per share
The dividend yield provides a good basic
measure for an investor to use in comparing the
dividend income from his or her current holdings
to potential dividend income available through
investing in other equities or mutual funds. In
regard to overall investment returns, it is
important to note that increases in share price
reduce the dividend yield ratio even though the
overall investment return from owning the stock
may have improved substantially. Conversely, a
drop in share price shows a higher dividend yield
but may indicate the company is experiencing
problems and lead to a lower total investment
return.
The dividend payout ratio is considered more
useful for evaluating a company's financial
condition and the prospects for maintaining or
improving its dividend payouts in the future. The
dividend payout ratio reveals the percentage
of net income a company is paying out in the
form of dividends. It is calculated using the
following equation:
Dividend payout ratio = annual dividends per
share / earnings per share
If the dividend payout ratio is excessively high,
this may indicate less likelihood a company will
be able to sustain such dividend payouts in the
future, due to the fact that the company is using a
smaller percentage of earnings to reinvest in
company growth. Therefore, a stable dividend
payout ratio is commonly preferred over an
unusually high dividend payout ratio. A good way
to determine if a company's payout ratio is a
reasonable one is to compare the ratio to that of
similar companies in the same industry.
How can the price-to-earnings (P/E)
ratio mislead investors?
The price-to-earnings (P/E) ratio is calculated by
dividing a companys stock price per share by
its earnings per share (EPS), giving investors an
idea of whether a stock is under- or overvalued.
While the P/E ratio is a useful
stock valuation measure, it can be misleading to
investors. One reason is that a P/E ratio based
on past data (as is the case with trailing P/E),
does not guarantee earnings will remain the
same. Likewise, if the P/E ratio is based on
projected earnings (for example, with a forward
P/E), there is no guarantee that estimates will be
accurate. And, accounting techniques can control
(or manipulate) financial reports. EPS, therefore,
can be skewed, depending on how the books are
done. This can make it difficult for investors to
accurately value a single company or compare
various companies since it may be impossible to
know if they are comparing similar figures.
Another problem is that there is more than one
way to calculate EPS. In the P/E ratio calculation,
the stock price per share is set by the market.
The EPS value, however, varies depending on
the earnings data used; for example, data from
the past twelve months or estimates for the
coming year. Comparing one companys P/E ratio
based on trailing earnings to anothers forward
earnings creates an apples-to-oranges
comparison that can be misleading to investors.
For these reasons, it is recommended that
investors use more than the P/E ratio when
evaluating a company or comparing various
companies.
A quick look at P/E ratios for Apple Inc (AAPL)
and Amazon.com Inc (AMZN) illustrates the
dangers in using only the P/E ratio to evaluate a
company. Apple was traded at $92.18 with a P/E
ratio (TTM) of 15.34. On the same day, Amazons
stock price was $334.38 with a P/E ratio of
511.06. One of the reasons Amazons P/E is so
high is that it always reinvests its earnings. If you
were to compare these two stocks based on P/E
alone, it would be impossible to make a
reasonable evaluation. A low P/E ratio doesnt
automatically mean a stock is undervalued, just
like a high P/E ratio doesnt necessarily mean it is
overvalued.
Working Capital
Working capital is a measure of both a
company's efficiency and its short-
term financial health. Working capital is
calculated as:
Working Capital = Current Assets - Current
Liabilities
The working capital ratio (Current
Assets/Current Liabilities) indicates whether a
company has enough short term assets to cover
its short term debt. Anything below 1
indicates negative W/C (working capital).
While anything over 2 means that the
company is not investing excess assets. Most
believe that a ratio between 1.2 and 2.0 is
sufficient. Also known as "net working capital".
If a company's current assets do not exceed
its current liabilities, then it may run into
trouble paying back creditors in the short
term. The worst-case scenario is bankruptcy. A
declining working capital ratio over a longer time
period could also be a red
flag that warrants further analysis. For example, it
could be that the company's sales volumes are
decreasing and, as a result, its
accounts receivables number continues to get
smaller and smaller.Working capital also gives
investors an idea of the company's
underlying operational efficiency. Money that is
tied up in inventory or money that customers still
owe to the company cannot be used to pay off
any of the company's obligations. So, if a
company is not operating in the most efficient
manner (slow collection), it will show up as an
increase in the working capital. This can be seen
by comparing the working capital from one period
to another; slow collection may signal an
underlying problem in the company's operations.
Things to Remember
If the ratio is less than one then they have
negative working capital.
A high working capital ratio isn't always a
good thing, it could indicate that they have
too much inventory or they are not
investing their excess cash
The Working
Capital Position
For investors, the strength of a
company's balance sheet can be evaluated by
examining three broad categories of
investment quality: working
capital adequacy, asset
performance and capitalization structure. In
this article, we'll start with a comprehensive
look at how best to evaluate the investment
quality of a company's working capital position. In
simple terms, this entails measuring
the liquidity and managerial efficiency related to a
company's current position. The analytical tool
employed to accomplish this task will be a
company's cash conversion cycle.
Don't Be Misled by Faulty Analysis
To start this discussion, let's first correct some
commonly held, but erroneous, views on a
company's current position, which simply
consists of the relationship between its current
assets and its current liabilities. Working capital is
the difference between these two broad
categories of financial figures and is expressed
as an absolute dollar amount.
Despite conventional wisdom, as a stand-alone
number, a company's current position has little or
no relevance to an assessment of its liquidity.
Nevertheless, this number is prominently
reported in corporate financial communications
such as the annual report and also by investment
research services. Whatever its size, the amount
of working capital sheds very little light on the
quality of a company's liquidity position.
Another piece of conventional wisdom that needs
correcting is the use of the current ratio and, its
close relative, the acid test or quick ratio.
Contrary to popular perception, these analytical
tools don't convey the evaluative information
about a company's liquidity that an investor
needs to know. The ubiquitous current ratio, as
an indicator of liquidity, is seriously flawed
because it's conceptually based on a company's
liquidation of all its current assets to meet all of
its current liabilities. In reality, this is not likely to
occur. Investors have to look at a company as
a going concern. It's the time it takes to convert a
company's working capital assets into cash to
pay its current obligations that is the key to its
liquidity. In a word, the current ratio is misleading.
A simplistic, but accurate, comparison of two
companies' current positions will illustrate the
weakness in relying on the current ratio and a
working capital number as liquidity indicators:
Liquidity Company Company
Measures ABC XYZ
Current Assets $600 $300
Current Liabilities $300 $300
Working Capital $300 $0
Current Ratio 2:1 1:1
At first glance, company ABC looks like an easy
winner in a liquidity contest. It has an ample
margin of current assets over current liabilities, a
seemingly good current ratio and a working
capital of $300. Company XYZ has no current
asset/liability margin of safety, a weak current
ratio and no working capital.
However, what if both companies' current
liabilities have an average payment period of 30
days? Company ABC needs six months (180
days) to collect its account receivables, and
its inventory turns over just once a year (365
days). Company XYZ's customers pay in cash,
and its inventory turns over 24 times a year
(every 15 days). In this contrived example,
company ABC is very illiquid and would not be
able to operate under the conditions described.
Its bills are coming due faster than its generation
of cash. You can't pay bills with working capital;
you pay bills with cash! Company XYZ's
seemingly tight current position is much more
liquid because of its quicker cash conversion.
Measuring a Company's Liquidity the Right
Way
The cash conversion cycle (also referred to as
CCC or the operating cycle) is the analytical tool
of choice for determining the investment quality of
two critical assets - inventory and accounts
receivable. The CCC tells us the time (number of
days) it takes to convert these two important
assets into cash. A fast turnover rate of these
assets is what creates real liquidity and is a
positive indication of the quality and the efficient
management of inventory and receivables. By
tracking the historical record (five to 10 years) of
a company's CCC and comparing it to competitor
companies in the same industry (CCCs will vary
according to the type of product and customer
base), we are provided with an insightful indicator
of a balance sheet's investment quality.
Briefly stated, the cash conversion cycle is
comprised of three standards: the so-
called activity ratios relating to the turnover of
inventory, trade receivables and trade payables.
These components of the CCC can be expressed
as a number of times per year or as a number of
days. Using the latter indicator provides a more
literal and coherent time measurement that is
easily understood. The cash conversion cycle
formula looks like this:
Days Inventory Outstanding (DIO) + Days
Sales Outstanding (DSO) Days Payable
Outstanding (DPO) = CCC
Here's how the components are calculated:
Dividing average inventories by cost of sales
per day (cost of sales/365) = days inventory
outstanding (DIO).
Dividing average accounts receivables by net
sales per day (net sales/365) = days sales
outstanding (DSO).
Dividing average accounts payables by cost
of sales per day (cost of sales/365) = days
payables outstanding (DPO).
Liquidity Is King
One collateral observation is worth mentioning
here. Investors should be alert to spotting liquidity
enhancers in a company's financial information.
For example, for a company that has non-
current investment securities, there is typically
a secondary market for the relatively quick
conversion of all or a high portion of these items
to cash. Also, unused committed lines of credit -
usually mentioned in a note to the financials on
debt or in the management discussion and
analysis section of a company's annual report -
can provide quick access to cash.
SEE: Understanding Financial Liquidity
The Bottom Line
The old adage that "cash is king" is as important
for investors evaluating a company's investment
qualities as it is for the managers running the
business. A liquidity squeeze is worse than a
profit squeeze. A key management function is to
make sure that a company's receivables and
inventory positions are managed efficiently. This
means ensuring an adequate level of product
availability and providing appropriate payment
terms, while at the same time making sure that
working capital assets don't tie up undue
amounts of cash. This is a balancing act for
managers, but an important one. It is important
because with high liquidity, a company can take
advantage of price discounts on cash purchases,
reduce short-term borrowings, benefit from a top
commercial credit rating and take advantage of
market opportunities.
The cash conversion cycle and its component
parts are useful indicators of a company's true
liquidity. In addition, the performance of DIO and
DSO is a good indicator of management's ability
to handle the important inventory and receivable
assets.
Working Capital
Works
Cash is the lifeline of a company. If this lifeline
deteriorates, so does the company's ability to
fund operations, reinvest and meet capital
requirements and payments. Understanding a
company's cash flow health is essential to
making investment decisions. A good way to
judge a company's cash flow prospects is to look
at its working capital management (WCM).
What Is Working Capital?
Working capital refers to the cash a business
requires for day-to-day operations, or, more
specifically, for financing the conversion of raw
materials into finished goods, which the company
sells for payment. Among the most important
items of working capital are levels of
inventory, accounts receivable and accounts
payable. Analysts look at these items for signs of
a company's efficiency and financial strength.
(Read more, in Free Cash Flow: Free, But Not
Always Easy.)
Take a simplistic case: a spaghetti sauce
company uses $100 to build up its inventory of
tomatoes, onions, garlic, spices etc. A week later,
the company assembles the ingredients into
sauce and ships it out. A week after that, the
checks arrive from customers. That $100, which
has been tied up for two weeks, is the company's
working capital. The quicker the company sells
the spaghetti sauce, the sooner the company can
go out and buy new ingredients, which will be
made into more sauce sold at a profit. If the
ingredients sit in inventory for a month, company
cash is tied-up and can't be used to grow the
spaghetti business. Even worse, the company
can be left strapped for cash when it needs to
pay its bills and make investments. Working
capital also gets trapped when customers do not
pay their invoices on time or suppliers get paid
too quickly or not fast enough.
The better a company manages its working
capital, the less the company needs to borrow.
Even companies with cash surpluses need to
manage working capital to ensure that those
surpluses are invested in ways that will generate
suitable returns for investors. (Get some more
background information, in The Working Capital
Position.)
Not All Companies are the Same
Some companies are inherently better placed
than others. Insurance companies, for instance,
receive premium payments up front before having
to make any payments; however, insurance
companies do have unpredictable cash outflow
as claims come in.
Normally, a big retailer like Wal-
Mart (NYSE:WMT) has little to worry about when
it comes to accounts receivable: customers pay
for goods on the spot. Inventories represent the
biggest problem for retailers; as such, they must
perform rigorous inventory forecasting or they
risk being out of business in a short time.
Timing and lumpiness of payments can pose
serious troubles. Manufacturing companies, for
example, incur substantial upfront costs for
materials and labor before receiving payment.
Much of the time they eat more cash than they
generate. (Find out how to do an analysis,
in Evaluating A Company's Capital Structure.)
Evaluating Companies
Investors should favor companies that place
emphasis on supply-chain management to
ensure that trade terms are optimized. Days-
sales outstanding, or DSO for short, is a good
indication of working capital management
practices. DSO provides a rough guide to the
number of days that a company takes to collect
payment after making a sale. Here is the simple
formula:
Receivables/ Annual Sales/365 Days
Rising DSO is a sign of trouble because it shows
that a company is taking longer to collect its
payments. It suggests that the company is not
going to have enough cash to fund short-term
obligations because the cash cycle is
lengthening. A spike in DSO is even more
worrisome, especially for companies that are
already low on cash.
The inventory turnover ratio offers another good
instrument for assessing the effectiveness of
WCM. The inventory ratio shows how fast/often
companies are able to get their goods completely
off the shelves. The inventory ratio looks like this:
Cost of Goods Sold (COGS)/Inventory
Broadly speaking, a high inventory turnover
ratio is good for business. Products that sit on the
shelf are not making money. Granted, an
increase in the ratio can be a positive sign,
indicating that management, expecting sales to
increase, is building up inventory ahead of time.
For investors, a company's inventory turnover
ratio is best seen in light of its competitors. In a
given sector where, for instance, it is normal for a
company to completely sell out and restock six
times a year, a company that achieves a turnover
ratio of four is an underperformer.
Computer giant and stock
market champion, Dell (Nasdaq:DELL),
recognized early that a good way to
bolster shareholder value was to notch up
working capital management. The company's
world-class supply-chain management system
ensures that DSO stays low. Improvements in
inventory turnover increase cash flow, all but
eliminating liquidity risk, leaving Dell with more
cash on the balance sheet to distribute to
shareholders or fund growth plans. (Read more,
in Don't Get Burned By The Burn Rate.)
Dell's exceptional WCM certainly exceeds those
of the top executives who do not worry enough
about the nitty-gritty of working capital
management. Some CEOs frequently see
borrowing and raising equity as the only way to
boost cash flow. Other times, when faced with a
cash crunch, instead of setting straight inventory
turnover levels and reducing DSO, these
management teams pursue rampant cost
cutting and restructuring that may later aggravate
problems.
Conclusion
Cash is king - especially at a time when
fundraising is harder than ever. Letting it slip
away is an oversight that investors should not
forgive. Analyzing a company's working capital
can provide excellent insight into how well a
company handles its cash, and whether it is likely
to have any on hand to fund growth and
contribute to shareholder value. (Read more, in Z
Marks The End.)
Evaluating a
Company's Capital
Structure
or stock investors that favor companies with good
fundamentals, a "strong" balance sheet is an
important consideration for investing in a
company's stock. The strength of a company's
balance sheet can be evaluated by three broad
categories of investment-quality
measurements: working capital adequacy; asset
performance; and capital structure. In this article,
we'll look at evaluating balance sheet strength
based on the composition of a company's capital
structure.
A company's capitalization (not to be confused
with market capitalization) describes the
composition of a company's permanent or long-
term capital, which consists of a combination of
debt and equity. A healthy proportion of equity
capital, as opposed to debt capital, in a
company's capital structure is an indication of
financial fitness.
Clarifying Capital Structure
Related Terminology
The equity part of the debt-equity relationship is
the easiest to define. In a company's capital
structure, equity consists of a company's
common and preferred stock plus retained
earnings, which are summed up in the
shareholders' equity account on a balance sheet.
This invested capital and debt, generally of the
long-term variety, comprises a company's
capitalization, i.e. a permanent type of funding to
support a company's growth and related assets.
A discussion of debt is less straightforward.
Investment literature often equates a company's
debt with its liabilities. Investors should
understand that there is a difference between
operational and debt liabilities it is the latter that
forms the debt component of a company's
capitalization but that's not the end of the debt
story.
Among financial analysts and investment
research services, there is no universal
agreement as to what constitutes a debt liability.
For many analysts, the debt component in a
company's capitalization is simply a balance
sheet's long-term debt. This definition is too
simplistic. Investors should stick to a stricter
interpretation of debt where the debt component
of a company's capitalization should consist of
the following: short-term borrowings (notes
payable); the current portion of long-term debt;
long-term debt; two-thirds (rule of thumb) of the
principal amount of operating leases; and
redeemable preferred stock. Using a
comprehensive total debt figure is a prudent
analytical tool for stock investors.
It's worth noting here that both international and
U.S. financial accounting standards boards are
proposing rule changes that would treat operating
leases and pension "projected-benefits" as
balance sheet liabilities. The new proposed rules
certainly alert investors to the true nature of
these off-balance sheet obligations that have all
the earmarks of debt.
Is There an Optimal Debt-Equity
Relationship?
In financial terms, debt is a good example of the
proverbial two-edged sword. Astute use
of leverage (debt) increases the amount of
financial resources available to a company for
growth and expansion. The assumption is that
management can earn more on borrowed funds
than it pays in interest expense and fees on these
funds. However, as successful as this formula
may seem, it does require that a company
maintain a solid record of complying with its
various borrowing commitments.
A company considered too highly-leveraged (too
much debt versus equity) may find its freedom of
action restricted by its creditors and/or may have
its profitability hurt as a result of paying
high interest costs. Of course, the worst-case
scenario would be having trouble meeting
operating and debt liabilities during periods of
adverse economic conditions. Lastly, a company
in a highly-competitive business, if hobbled by
high debt, may find its competitors taking
advantage of its problems to grab more market obligations categorized as debt + total
share. shareholders' equity) to the equity component.
Expressed as a percentage, a low number is
Unfortunately, there is no magic proportion of indicative of a healthy equity cushion, which is
debt that a company can take on. The debt- always more desirable than a high percentage of
equity relationship varies according to industries debt.
involved, a company's line of business and its
stage of development. However, because
Additional Evaluative Debt-Equity
investors are better off putting their money into
companies with strong balance sheets, common Considerations
sense tells us that these companies should have, Companies in an aggressive acquisition mode
generally speaking, lower debt and higher equity can rack up a large amount of
levels. purchased goodwill in their balance sheets.
Investors need to be alert to the impact
Capital Ratios and Indicators of intangibles on the equity component of a
company's capitalization. A material amount of
In general, analysts use three ratios to assess
intangible assets need to be considered carefully
the financial strength of a company's
for its potential negative effect as a deduction (or
capitalization structure. The first two, the so-
impairment) of equity, which, as a consequence,
called debt and debt/equity ratios, are popular
will adversely affect the capitalization ratio.
measurements; however, it's the capitalization
ratio that delivers the key insights to evaluating a
Funded debt is the technical term applied to the
company's capital position.
portion of a company's long-term debt that is
made up of bonds and other similar long-term,
The debt ratio compares total liabilities to total
fixed-maturity types of borrowings. No matter how
assets. Obviously, more of the former means less
problematic a company's financial condition may
equity and, therefore, indicates a more leveraged
be, the holders of these obligations cannot
position. The problem with this measurement is
demand payment as long as the company pays
that it is too broad in scope, which, as a
the interest on its funded debt. In contrast, bank
consequence, gives equal weight to operational
debt is usually subject to acceleration clauses
and debt liabilities. The same criticism can be
and/or covenants that allow the lender to call its
applied to the debt/equity ratio, which compares
loan. From the investor's perspective, the greater
total liabilities to total shareholders' equity.
the percentage of funded debt to total debt
Current and non-current operational liabilities,
disclosed in the debt note in the notes to financial
particularly the latter, represent obligations that
statements, the better. Funded debt gives a
will be with the company forever. Also, unlike
company more wiggle room.
debt, there are no fixed payments of principal or
interest attached to operational liabilities.
Lastly, credit ratings are formal risk evaluations
by credit-rating agencies Moody's, Standard &
The capitalization ratio (total debt/total
Poor's, Duff & Phelps and Fitch of a
capitalization) compares the debt component of a
company's ability to repay principal and interest
company's capital structure (the sum of
on debt obligations, principally bonds
and commercial paper. Here again, this
information should appear in the footnotes.
Obviously, investors should be glad to see high-
quality rankings on the debt of companies they
are considering as investment opportunities
and be wary of the reverse.
The Bottom Line
A company's reasonable, proportional use of
debt and equity to support its assets is a key
indicator of balance sheet strength. A healthy
capital structure that reflects a low level of debt
and a corresponding high level of equity is a very
positive sign of investment quality.
Due Diligence
What is 'Due Diligence'
Due diligence is an investigation or audit of a
potential investment to confirm all facts, such as
reviewing all financial records, plus anything else
deemed material. Due diligence refers to the care
a reasonable person should take before entering
into an agreement or a financial transaction with
another party. When sellers perform a due
diligence analysis on buyers, items that may be
considered are the buyer's ability to purchase, as
well as other elements that would affect the
acquired entity or the seller after the sale has
been completed.
An individual investor performs due diligence by
studying annual reports, Securities and
Exchange Commission (SEC) filings and other
relevant information about a business and its
securities. An investor verifies the material facts
related to purchasing the investment and
determines whether it fits his return requirements,
risk tolerance, income needs and asset allocation
goals. For example, an investor may read the
companys last two annual reports, several recent
10-Qs, and any independent research available.
He can then develop a sense of where the
business is heading, what market factors may
affect the stocks price and how volatile the stock
is. The investor then has guidance on whether
the investment is right for him, and how much
and when to purchase it.
BREAKING DOWN 'Due
Diligence'
Due diligence came into being when the U.S.
Securities Act of 1933 was passed. Securities
dealers and brokers became responsible for fully
disclosing material information related to the
instruments they were selling. Failing to disclose
material information made dealers and brokers
liable for criminal prosecution. However, creators
of the Act understood that requiring full disclosure
left the securities dealers and brokers vulnerable
to unfair prosecution if they did not disclose a
material fact they did not possess or could not
have known at the time of sale. As a means of
protecting the dealers and brokers, the Act
included a legal defense that stated that as long
as the dealers and brokers exercised due
diligence when investigating companies whose
equities they were selling, and fully disclosed
their results to investors, they would not be held
liable for information not discovered during the
investigation.
What are Historic Cases of approved, but the subsequent 80% decline in the
value of the shares of AOL-Time Warner, the
Companies Failing to Do their precipitous decline in America Online subscribers
Due Diligence? with the advent of broadband, DSL and other,
faster Internet gateways, and the 2009 sale of
A historic case of a company failing to
America Online's (renamed AOL) assets by Time
conduct proper due diligence is when Time
Warner for a fraction of their original worth (about
Warner was acquired by America Online in
$3.15 billion) suggests that this due diligence
January 2000. America Online was founded in
may have been performed hastily. It was the
the early 1980s as Control Video Corporation,
largest merger ever and has been called the
and at that time it was a small, barely noticed
worst in history.
technology company that changed names and
focus several times. In 1991, Steve Case took
over as CEO, and America Online went public on What is a Due Diligence
March 19, 1992. In 1993, the company had Meeting?
600,000 subscribers. By 1996 it had ten times
A due diligence meeting is the process of careful
that number. When the company acquired Time
investigation by an underwriter to ensure that all
Warner in 2000, it had 25 million subscribers and
material information pertinent to a security issue
a market capitalization of $175 billion. Even with
has been disclosed to prospective investors.
this growth and heady market cap, the company
had relatively small revenues of $5 billion. Before issuing a final prospectus, the underwriter,
issuer and other individuals involved (such as
Time Warner, at the time of the merger, had a
accountants, syndicate members, and attorneys),
market capitalization of $90 billion and $27 billion
will gather to discuss whether the underwriter and
in revenues. Markets saw America Online's
issuer have exercised due diligence toward state
growing profits as more valuable than Time
and federal securities laws. Below are steps to
Warner's more steady profits. The Nasdaq
take to do your due diligence as an individual
Composite Index and many technology
investor.
companies were experiencing similar growth and
valuations. Many believed they were on the brink
The Due Diligence Process
of the dawn of a new era in publishing, and to
Step 1: Analyze the Capitalization of the
some extent they were right. However, America
Company
Online never met up to these expectations.
These factors led to Time Warner's CEO Gerald
The first step in doing due diligence is to
Levin allowing his company, with roots going
determine just how big the company is. The
back to 1922, to be acquired by America Online.
companys market capitalization says a lot about
how volatile the stock is likely to be, how broad
America Online's highly valued stock was the
the ownership might be and the potential size of
currency that permitted the transaction to take
the company's end markets. For example, large
place. Teams of lawyers for both companies
cap and mega cap companies tend to have more
performed due diligence before the deal was
stable revenue streams and less volatility. Mid
cap and small cap companies, meanwhile, may
only serve single areas of the market, and may
have more fluctuations in their stock price and
earnings. (To learn more about market cap,
see: Market Capitalization
Defined and Determining What Market Cap Suits
Your Style.) When you start to examine revenue
and profit figures, the market cap will give you
some perspective.
You should also confirm one other vital fact on
this first check: what stock exchange do the
shares trade on? Are they based in the United
States (such as the New York Stock
Exchange, Nasdaq, or over the counter)? Or, are
they American depositary receipts (ADRs) with
another listing on a foreign exchange? ADRs will
typically have the letters "ADR" written
somewhere in the reported title of the share
listing. This information along with market cap
should help answer basic questions like whether
you can own the shares in your current
investment accounts.
Step 2: Revenue, Profit, and Margin Trends
When beginning to look at the numbers, it may
be best to start with
the revenue, profit and margin (RPM) trends.
Look up the revenue and net income trends for
the past two years at a general finance website.
These should have links to quarterly (for the past
12 months) and annual reports (past three
years). A quick calculator check could be done to
confirm the price-to-sales (P/S) ratio and
the price-to-earnings (P/E) ratio. Look at the
recent trends in both sets of figures, noting
whether growth is choppy or consistent, or if
there any major swings (such as more than 50%
in one year) in either direction.
Margins should also be reviewed to see if they
are generally rising, falling, or remaining the
same. This information will come into play more
during the next step.
Step 3: Competitors and Industries
Now that you have a feel for how big the
company is and how much money it earns, it's
time to size up the industries it operates in and
who it competes with. Compare the margins of
two or three competitors. Every company is
partially defined by its competition. Looking at the
major competitors in each line of business (if
there is more than one) may help you nail down
just how big the end markets for products are. Is
the company being considered for investment a
leader in its industry?
Information about competitors can be found in
company profiles on most major research sites,
usually along with their ticker or direct
comparisons that let you review a list of certain
metrics filled in for both the company you're
researching and its competitors. If you're still
uncertain of how the company's business
model works, you should look to fill in any gaps
here before moving further along. Sometimes just
reading about some of the competitors may help
to understand what your target company does.
BlackBerry Ltd., formerly known as Research in
Motion Ltd., was an undisputed leader until Apple
Inc.s iPhone and others like Samsung out-
innovated BlackBerry. Investors aware of industry
developments can better protect their
investments.
Step 4: Valuation Multiples
Now it's time to get to the nitty-gritty of
P/Es, price/earnings to growth (PEGs) ratio, and
the like, for both the company and its considered fairly valued under normal market
competitors. Note any large discrepancies conditions.
between competitors for further review. It's not
uncommon to become more interested in a Step 5: Management and Share Ownership
competitor during this step, which is perfectly fine
Is the company still run by its founders? Or has
but still look to follow through with the original
management and the board shuffled in a lot of
due diligence while noting the other competing
new faces? The age of the company is a big
company for further review down the road.
factor here, as younger companies tend to have
P/E ratios can form the initial basis for looking at more of the founding members still around. Look
valuations. While earnings can and will have at consolidated bios of top managers to see what
some volatility (even at the most stable kind of broad experiences they have; this
companies), valuations based on trailing information may be found on the company's
earnings or on current estimates are a yardstick website or on SEC filings.
that allows instant comparison to broad market
Also look to see if founders and managers hold a
multiples or direct competitors. Basic "growth
high proportion of shares, and what amount of
stock" versus "value stock" distinctions can be
the float is held by institutions. Institutional
made here along with a general sense of how
ownership percentages indicate how
much expectation is built into the company. It's
much analyst coverage the company is getting as
generally a good idea to examine a few years'
well as factors influencing trade volumes.
worth of net earnings figures to make sure most
Consider high personal ownership by top
recent earnings figure (and the one used to
managers as a plus, and low ownership a
calculate the P/E) is normalized, and not being
potential red flag. Shareholders tend to be best
thrown off by a significant one-time adjustment or
served when the people running the company
charge.
have a stake in the performance of the stock. (To
Not to be used in isolation, the P/E should be learn about the value of this vested interest see,
looked at in conjunction with the price-to-book check out: Evaluating A Company's
(P/B) ratio, the enterprise multiple, and the price- Management and Delving Into Insider
to-sales (or revenue) ratio. These multiples Investments.)
highlight the valuation of the company as it
Step 6: Balance Sheet Exam
relates to its debt, annual revenues, and the
balance sheet. Because ranges in these values
Many articles could easily be devoted to just the
differ from industry to industry, reviewing the
balance sheet, but for our initial due diligence
same figures for some competitors or peers is a
purposes, a cursory exam will do. Look up a
critical step.
consolidated balance sheet to see the overall
level of assets and liabilities, paying special
Finally, the PEG ratio brings into account the
attention to cash levels (the ability to pay short-
expectations for future earnings growth, and how
term liabilities) and the amount of long-term
it compares to the current earnings multiple.
debt held by the company. A lot of debt is not
Stocks with PEG ratios close to one are
necessarily a bad thing, especially depending on
the company's business model. Some companies
(and industries as a whole) are very capital
intensive, while others require little more than the
basics of employees, equipment, and a novel
idea to get up and running. Look at the debt-to-
equity ratio to see how much positive equity the
company has going for it; you can then compare
this with the competitors to put the metric into
better perspective.
If the "top line" balance sheet figures of total
assets, total liabilities and stockholders'
equity change substantially from one year to the
next, try to determine why. Reading
the footnotes that accompany the financial
statements and the management's discussion in
the quarterly/annual report can shed some light
on the situation. The company could be preparing
for a new product launch, accumulating retained
earnings or simply whittling away at precious
capital resources. What you see should start to
have some deeper perspective after having
reviewed the recent profit trends.
Step 7: Stock Price History
At this point, you'll want to nail down just how
long all classes of shares have been trading, and
both short-term and long-term price movement.
Has the stock price been choppy and volatile, or
smooth and steady? This outlines what kind of
profit experience the average owner of the stock
has seen, which can influence future stock
movement. Stocks that are continuously volatile
tend to have short-term shareholders, which can
add extra risk factors to certain investors.
Step 8: Stock Options and Dilution Possibilities
Next, investors will need to dig into the 10-
Q and 10-K reports. Quarterly SEC filings are
required to show all outstanding stock options as
well as the conversion expectations given a
range of future stock prices. Use this to help
understand how the share count could change
under different price scenarios. While employee
stock options are potentially a powerful motivator,
watch out for shady practices like re-issuing of
"underwater" options or any formal investigations
that have been made into illegal practices
like options backdating.
Step 9: Expectations
This is a sort of a "catch-all," and requires some
extra digging. Investors should find out what
the consensus revenue and profit estimates are
for the next two to three years, long-term trends
affecting the industry and company specific
details about partnerships, joint
ventures, intellectual property, and new
products/services. News about a product or
service on the horizon may be what initially
turned you on to the stock, and now is the time to
examine it more fully with the help of everything
you've accumulated thus far.
Step 10: Examine Long and Short-term Risks
Setting this vital piece aside for the end makes
sure that we're always emphasizing
the risks inherent with investing. Make sure to
understand both industry-wide risks and
company-specific ones. Are there outstanding
legal or regulatory matters, or just a spotty history
with management? Is the company eco-friendly?
And, what kind of long-term risks could result
from it embracing/not embracing green
initiatives? Investors should keep a healthy devil's
advocate going at all times, picturing worst-case
scenarios and their potential outcomes on the
stock.
Once you've completed these steps, you should
be able to wrap your mind around what the
company has done so far, and how it might fit into
a broad portfolio or investment strategy.
Inevitably you'll have specifics that you will want
to research further, but following these guidelines
should save you from missing something that
could be vital to your decision. Veteran investors
will throw many more investment ideas into the
trash bin then they will keep for further review, so
never be afraid to start over with a fresh idea and
a new company. There are thousands of stocks
to pick from.
What are the Due Diligence
Basics for Investing in a
Startup?
When considering investing in a startup, follow
the above-mentioned steps, in addition to the
startup-specific criteria below. Investing in a
startup carries a high level of risk, so here are
basic steps you should consider.
Include an exit strategy when planning:
More than 50% of startups fail within the
first two years. Plan
your divestment strategy to recover your
investments should the business fail. This
safeguards you from losing all of your
investment.
Consider entering into a partnership:
Partners split the capital and risk among
themselves. Thus, there is a lower risk,
and you lose fewer resources should the
business fail in the first few years.
Figure out the harvest strategy for your
investment: Promising businesses may fail
due to a change in technology,
government policy or the market. Be on
the lookout for new trends, technologies
and brands, and harvest when you find
that the business may not thrive with the
introduction of new factors in the market.
Choose a startup with promising products:
Since most investments are harvested
after five years, it is advisable to invest in
products that have an increasing return on
investment (ROI) for the period.
Furthermore, look at the growth plan of
the business, and evaluate whether it is
viable.
Introduction To
Dividends
When a company earns profits from
operations, management can do one of two
things with those profits. It can choose to
retain them - essentially reinvesting them into
the company with the hope of creating more
profits and thus further stock appreciation.
The alternative is to distribute a portion of the
profits to shareholders in the form of
dividends. Management can also opt to
repurchase some of its own shares - a move
that would also benefit shareholders.
A company must keep growing at an above-
average pace to justify reinvesting in itself
rather than paying a dividend. Generally
speaking, when a company's growth slows, its
stock won't climb as much, and dividends will
be necessary to keep shareholders around.
This growth slowdown happens to virtually all
companies after they attain a large market
capitalization. A company will simply reach a
size at which it no longer has the potential to
grow at annual rates of 30-40% like a small
cap, regardless of how much money is
plowed back into it. At a certain point, the law
of large numbers makes a mega-
cap company and growth rates that
outperform the market an impossible
combination. In this section, we'll take a
deeper look at the different types of dividends
and the mechanics of dividend payments;
how companies establish dividend policy and
the different types of dividend policies; the
reasons why companies and investors might
prefer higher, lower or no dividend payments;
and share repurchases, stock splits and stock
dividends as an alternative to cash dividends.
Cash
Dividends And
Dividend
Payment
A cash dividend is money paid to
stockholders, normally out of the corporation's
current earnings or accumulated profits. Not
all companies pay a dividend. Usually, the
board of directors determines if a dividend is
desirable for their particular company based
upon various financial and economic factors.
Dividends are commonly paid in the form of
cash distributions to the shareholders on a
monthly, quarterly or yearly basis. All
dividends are taxable as income to the
recipients.
Dividends are normally paid on a per-share
basis. If you own 100 shares of the ABC
Corporation, the 100 shares is your basis for
dividend distribution. Assume for the moment
that ABC Corporation was purchased at
$100/share, which implies a $10,000 total
investment. Profits at the ABC Corporation
were unusually high so the board of directors
agrees to pay its shareholder $10 per share
annually in the form of a cash dividend. So,
as an owner of ABC Corporation for a year,
your continued investment in ABC Corp
should give us $1,000 in dividend dollars. The
annual yield is the total dividend amount
($1,000) divided by the cost of the stock
($10,000) which gives us in percentage
terms, 10%. If the 100 shares of ABC
Corporation were purchased at $200 per
share, the yield would drop to 5%, since 100
shares now cost $20,000, or your original
$10,000 only gets you 50 shares instead of
100. If the price of the stock moves higher,
then dividend yield drops and vice versa. The
Mechanics of Dividends
Do dividend-paying stocks make a good
overall investment? Dividends are derived
from a company's profits, so it is fair to
assume that dividends are generally a sign of
financial health. From an investment strategy
perspective, buying established companies
with a history of good dividends adds stability
to a portfolio. Your $10,000 investment in
ABC Corporation, if held for one year, will be
worth $11,000, assuming the stock price after
one year is unchanged. Moreover, if ABC
Corporation is trading at $90 share a year
after you purchased for $100 a share, your
total investment after receiving dividends still
breaks even ($9,000 stock value + $1,000 in
dividends).
Herein lies the appeal to buying stocks with
dividends: they help cushion declines in
actual stock prices, and they also present an
opportunity for stock price
appreciation coupled with the steady stream
of income that dividends provide.
This is why many investing legends such
as John Bogle, Warren Buffett and Benjamin
Graham all espouse the virtues of buying
stocks that pay a dividend as a critical part of
the investment return of an asset. (Discover
the issues that complicate these payouts for
investors Dividend Facts You May Not Know.)
Risks to Dividends
During the financial meltdown in 2008-2009,
all of the major banks either slashed or
eliminated their dividend payouts. These
companies were known for consistent, stable
dividend payouts each quarter for hundreds of
years, yet despite their storied history, the
dividends were cut.
The lesson is that dividends are not
guaranteed and are subject
to macroeconomic as well as company-
specific risks. Another potential downside to
investing in dividend-paying stocks is that
companies that pay dividends are not usually
high growth leaders. There are a few
exceptions, but high-growth companies
usually do not pay dividends to shareholders
even if they have significantly outperformed
over the vast majority of all stocks over the
last five years. Growth companies tend to
spend more dollars on research and
development, capital expansion, retaining
talented employees and/or mergers and
acquisitions, which leaves them with little to
no money to spend on dividends.
For these companies, all earnings are
considered retained earnings and are
reinvested back into the company instead of
rewarding loyal shareholders.
It is equally important to beware of companies
with extraordinarily high yields. As we have
learned, if a company's stock price continues
to decline, its yield goes up. Many rookie
investors get teased into purchasing a stock
just on the basis of a potential juicy dividend.
However, there is no specific rule of thumb in
relation to how much is too much in terms of a
dividend payout.
The average dividend yield on the S&P
500 companies that pay a dividend historically
fluctuates somewhere between 2-5%,
depending on market conditions. In general, it
pays to do your homework on stocks yielding
more than 8% to find out what is truly going
on with the company. Doing this due
diligence will help you decipher those
companies that are truly in financial shambles
from those that are temporarily out of favor
and therefore present a good investment. (To
read more on this subject, see Why
Dividends Matter, How Dividends Work For
Investors and 6 Common Misconceptions
About Dividends.)
How Companies Pay Dividends
Dividend payouts follow a set procedure. To
understand it, first we'll define the following
terms:
1. Declaration Date
The declaration date is the day the company's
board of directors announces approval of the
dividend payment.
2. Ex-Dividend Date
The ex-dividend date is the date on which
investors are cut off from receiving a dividend.
If, for example, an investor purchases a stock
on the ex-dividend date, that investor will not
receive the dividend. This date is two
business days before the holder-of-record
date.
The ex-dividend date is important because
from this date forward, new stockholders will
to the dividend.
3. At the close of business on Feb. 27, all
holders of Newco's stock are recorded, and
those holders will receive the dividend.
4. On Mar. 17, the payment date, Newco
mails the dividend checks to the holders of
record.

Dividend
not receive the dividend, and the stock price
reflects this fact. For example, on and after
the ex-dividend date, a stock usually trades at

Policy
a lower price as the stock price adjusts for the
dividend that the new holder will not receive.

3. Holder-of-Record Date
Dividend policy is the set of guidelines a
The holder-of-record (owner-of-record) date is
company uses to decide how much of its
the date on which the stockholders who are
earnings it will pay out to shareholders. Some
eligible to receive the dividend are
evidence suggests that investors are not
recognized.
concerned with a company's dividend policy
since they can sell a portion of their portfolio
(Understanding the dates of the dividend
of equities if they want cash. This evidence is
payout process can be tricky. We clear up the
called the "dividend irrelevance theory," and it
confusion in Declaration, Ex-Dividend and
essentially indicates that an issuance of
Record Date Defined.)
dividends should have little to no impact on
stock price. That being said, many companies
4. Payment Date
do pay dividends, so let's look at how they do
Last is the payment date, the date on which
it.
the actual dividend is paid out to the
stockholders of record.
There are three main approaches to
dividends: residual, stability or a hybrid of the
Example: Dividend Payment
two.
Suppose Newco would like to pay a dividend
to its shareholders. The company would
Residual Dividend Policy
proceed as follows:
Companies using the residual dividend policy
choose to rely on internally
1. On Jan. 28, the company declares it will
generated equity to finance any new projects.
pay its regular dividend of $0.30 per share to
As a result, dividend payments can come out
holders of record as of Feb. 27, with payment
of the residual or leftover equity only after all
on Mar. 17.
project capital requirements are met. These
2. The ex-dividend date is Feb. 23 (usually
companies usually attempt to maintain
four days before of the holder-of-record date).
balance in their debt/equity ratios before
As of Feb. 23, new buyers do not have a right
making any dividend distributions, deciding on
dividends only if there is enough money left
over after all operating and expansion
expenses are met.
For example, let's suppose that a company
named CBC has recently earned $1,000 and
has a strict policy to maintain a debt/equity
ratio of 0.5 (one part debt to every two parts
of equity). Now, suppose this company has a
project with a capital requirement of $900. In
order to maintain the debt/equity ratio of 0.5,
CBC would have to pay for one-third of this
project by using debt ($300) and two-thirds
($600) by using equity. In other words, the
company would have to borrow $300 and use
$600 of its equity to maintain the 0.5 ratio,
leaving a residual amount of $400 ($1,000 -
$600) for dividends. On the other hand, if the
project had a capital requirement of $1,500,
the debt requirement would be $500 and the
equity requirement would be $1,000, leaving
zero ($1,000 - $1,000) for dividends. If any
project required an equity portion that was
greater than the company's available levels,
the company would issue new stock.
Typically, this method of dividend payment
creates volatility in the dividend payments that
some investors find undesirable.
The residual-dividend model is based on
three key pieces: an investment opportunity
schedule (IOS), a target capital structure and
a cost of external capital.
1. The first step in the residual dividend model
to set a target dividend payout ratio to
determine the optimal capital budget.
2. Then, management must determine the
equity amount needed to finance the optimal
capital budget. This should be done primarily
through retained earnings.
3. The dividends are then paid out with the
leftover, or residual, earnings. Given the use
of residual earnings, the model is known as
the "residual-dividend model."
A primary advantage of the dividend-residual
model is that with capital-projects budgeting,
the residual-dividend model is useful in
setting longer-term dividend policy. A
significant disadvantage is that dividends may
be unstable. Earnings from year to year can
vary depending on business situations. As
such, it is difficult to maintain stable earnings
and thus a stable dividend. While the
residual-dividend model is useful for longer-
term planning, many firms do not use the
model in calculating dividends each quarter.
Dividend Stability Policy
The fluctuation of dividends created by the
residual policy significantly contrasts with the
certainty of the dividend stability policy. With
the stability policy, quarterly dividends are set
at a fraction of yearly earnings. This policy
reduces uncertainty for investors and
provides them with income.
Suppose our imaginary company, CBC,
earned $1,000 for the year (with quarterly
earnings of $300, $200, $100 and $400). If
CBC decided on a stable policy of 10% of
yearly earnings ($1,000 x 10%), it would pay
$25 ($100/4) to shareholders every quarter.
Alternatively, if CBC decided on a cyclical
policy, the dividend payments would adjust
every quarter to be $30, $20, $10 and $40,
respectively. In either instance, companies
following this policy are always attempting to
share earnings with shareholders rather than
searching for projects in which to invest
excess cash.
Hybrid Dividend Policy
The final approach is a combination between
the residual and stable dividend policy. Using
this approach, companies tend to view the
debt/equity ratio as a long-term rather than a
short-term goal. In today's markets, this
approach is commonly used by companies
that pay dividends. As these companies will
generally experience business cycle
fluctuations, they will generally have one set
dividend, which is set as a relatively small
portion of yearly income and can be easily
maintained. On top of this set dividend, these
companies will offer another extra dividend
paid only when income exceeds general
levels.
Real-World
Factors
Affecting
Dividend
Payouts
Real-World Factors Affecting Low
Dividend Payouts
As we mentioned earlier, some financial
analysts feel that the consideration of
a dividend policy is irrelevant. They contend
that investors have the ability to create
"homemade" dividends by adjusting their
personal portfolios to reflect their own
preferences. For example, investors looking
for a steady stream of income are more likely
to invest in bonds (in which interest payments
don't change) than in a dividend-paying stock
(in which value can fluctuate). Because their
interest payments won't change, those who
own bonds don't care about a particular
company's dividend policy. The second
argument claims that little to no dividend
payout is more favorable for investors.
Supporters of this policy point out that
taxation on a dividend is higher than on
a capital gain. The argument against
dividends is based on the belief that a firm
that reinvests funds (rather than paying them
out as dividends) will increase the value of the
firm as a whole and consequently increase
the market value of the stock. When investors
sell, they profit from a lower-taxed capital
gain. According to the proponents of the no-
dividend policy, investors benefit more in the
long run from the company's undertaking
more projects, repurchasing its own shares,
acquiring new companies and profitable
assets, and reinvesting in financial assets.
(Keep reading about capital gains in Tax
Effects On Capital Gains.)
A third argument in favor of low dividends is
the high cost to a firm of issuing new stock. In
other words, to avoid the need to raise money
through the issuance of new stock, which is
expensive, firms should retain most or all of
their earnings and pay little to no dividends to
investors.
Real-World Factors Affecting High
Dividend Payouts
In opposition to these three arguments is the
idea that a high dividend payout is important
for investors because dividends provide
certainty about the company's financial well-
being; dividends are also attractive for
 investors looking to secure current income.
In addition, there are many examples of how
the decrease and increase of a dividend
distribution can affect the price of a security.
Companies that have a long-standing history
of stable dividend payouts would be
negatively affected by lowering or omitting
dividend distributions; on the other hand,
these companies would be positively affected
by increasing dividend payouts or making
additional payouts of the same dividends.
Furthermore, companies without a dividend
history are generally viewed favorably when
they declare new dividends. (For more,
see Dividends Still Look Good After All These
Years.
Stock repurchase
Stock repurchase may be viewed as an
alternative to paying dividends in that it is another
method of returning cash to investors. A stock
repurchase occurs when a company asks
stockholders to tender their shares for
repurchase by the company. There are several
reasons why a stock repurchase can increase
value for stockholders. First, a repurchase can be
used to restructure the company's capital
structure without increasing the company's debt
load. Additionally, rather than a company
changing its dividend policy, it can offer value to
its stockholders through stock repurchases,
keeping in mind that capital gains taxes are lower
than taxes on dividends.
Advantages of a Stock Repurchase
Many companies initiate a share repurchase at a
price level that management deems a good entry
point. This point tends to be when the stock is
estimated to be undervalued. If a company
knows its business and relative stock price well,
would it purchase its stock price at a high level?
The answer is no, leading investors to believe
that management perceives its stock price to be
at a low level.
Unlike a cash dividend, a stock repurchase gives
the decision to the investor. A stockholder can
choose to tender his shares for repurchase,
accept the payment and pay the taxes. With a
cash dividend, a stockholder has no choice but to
accept the dividend and pay the taxes.
At times, there may be a block of shares from
one or more large shareholders that could come
into the market, but the timing may be unknown.
This problem may actually keep potential
stockholders away since they may be worried
about a flood of shares coming onto the market
and lessening the stock's value. A stock
repurchase can be quite useful in this situation.
Disadvantage of a Stock Repurchase
From an investor's perspective, a cash dividend
is dependable; a stock repurchase, however, is
not. For some investors, the dependability of the
dividend may be more important. As such,
investors may invest more heavily in a stock with
a dependable dividend than in a stock with less
dependable repurchases.
In addition, a company may find itself in a
position where it ends up paying too much for the
stock it repurchases. For example, say a
company repurchases its shares for $30 per
share on June 1. On June 10, a major hurricane
damages the company's primary operations. The
company's stock therefore drops down to $20.
Thus, the $10-per-share difference is a lost
opportunity to the company.
Overall, stockholders who offer their shares for
repurchase may be at a disadvantage if they are
not fully aware of all the details. As such, an
investor may file a lawsuit with the company,
which is seen as a risk.
Price Effect of a Stock Repurchase
A stock repurchase typically has the effect of
increasing the price of a stock.
Example: Newco has 20,000 shares outstanding
and a net income of $100,000. The current stock
price is $40. What effect does a 5% stock
repurchase have on the price per share of
Newco's stock?
Answer: To keep it simple, price-per-earnings
ratio (P/E) is the valuation metric used to value
Newco's price per share.
Newco's current EPS = $100,000/20,000 = $5
per share
P/E ratio = $40/$5 = 8x
With a 2% stock repurchase, the following
occurs:
Newco's shares outstanding are reduced to
19,000 shares (20,000 x (1-.05))
Newco's EPS = $100,000/19,000 = $5.26
Given that Newco's shares trade on eight times
earnings, Newco's new share price would be $42,
an increase from the $40 per share before the
repurchase. (Read more about stock
repurchases in Market News That Seems
Promising But Isn't and Top Perks Warren Buffett
Gets When Purchasing Equities.)
Stock Dividends
And Stock Splits
Like cash dividends, stock dividends and stock
splits also have effects on a company's stock
price. Stock Dividends
Stock dividends are similar to cash dividends;
however, instead of cash, a company pays out
stock. As a result, a company's shares
outstanding will increase, and the company's
stock price will decrease. For example, suppose
Newco decides to issue a 10% stock dividend.
Each current stockholder will thus have 10%
more shares after the dividend is issued.
Stock Splits
Stock splits occur when a company perceives
that its stock price may be too high. Stock splits
are usually done to increase the liquidity of the
stock (more shares outstanding) and to make it
more affordable for investors to buy regular lots
(a regular lot = 100 shares). Companies tend to
want to keep their stock price within an optimal
trading range.
Stock splits increase the number of shares
outstanding and reduce the par or stated value
per share of the company's stock. For example, a
two-for-one stock split means that the company
stockholders will receive two shares for every
share they currently own. The split will double the
number of shares outstanding and reduce by half
the par value per share. Existing shareholders
will see their shareholdings double in quantity,
but there will be no change in the proportional
ownership represented by the shares. For
example, a shareholder owning 2,000 shares out
of 100,000 before a stock split would own 4,000
shares out of 200,000 after a stock split.
Stock Split Example:
Suppose Newco's stock reaches $60 per share.
The company's management believes this is too
high and that some investors may not invest in
the company as a result of the initial price
required to buy the stock. As such, the company
decides to split the stock to make the entry point
of the shares more accessible.
For simplicity, suppose Newco initiates a 2-for-1
stock split. For each share they own, all holders
of Newco stock will receive two Newco shares
priced at $30 each, and the company's shares
outstanding will double. Keep in mind that the
company's overall equity value remains the
same. Say there are one million shares
outstanding and the company's initial equity value
is $60 million ($60 per share x 1 million shares
outstanding). The equity value after the split is
still $60 million ($30 per share x 2 million shares
outstanding).
While stock prices will most likely rise after a split
or dividend (remember price increases are
caused by positive signals a company generates
with respect to future earnings), if positive news
does not follow, the company's stock price will
generally fall back to its original level. Some
investors think that stock splits and stock
dividends are unnecessary and do little more
than create more stocks. (For further reading on
stock splits, see Berkshire's Stock Splits: Good
Buy or Goodbye? and Top Stock Target Price
Misfires.)
Dividend Policy
What is a 'Dividend Policy'
A dividend policy is the policy a company uses to
decide how much it will pay out to shareholders
in the form of dividends. Some research and
economic logic suggests that dividend policy may
be irrelevant (in theory), but many investors rely
on dividends as a vital source of income.
BREAKING DOWN 'Dividend
Policy'
Because dividends represent a form of income
for investors, a company's dividend policy is an
important consideration for some investors. As
such, it is an important consideration for
company leadership, especially because
company leaders are often the largest
shareholders and have the most to gain from a
generous dividend policy. Most companies view a
dividend policy as an integral part of the
corporate strategy. Management must decide on
the dividend amount, timing and various other
factors that influence dividend payments over
time. There are three types of dividend policies: a
stable dividend policy, a constant dividend policy
and a residual dividend policy.
Stable Dividend Policy
The stable dividend policy is the easiest and
most commonly used policy. The goal of the
policy is to aim for steady and predictable
dividend payouts every year, which is what most
investors are seeking. When earnings are up,
investors receive a dividend. When earnings are
down, investors receive a dividend. The goal is to
align the dividend policy with the long-term
growth of the company rather than with quarterly
earnings volatility. This approach allows the
shareholder to have more certainty around the
amount and timing of the dividend.
Constant Dividend Policy
The primary drawback of the stable dividend
policy is that, in booming years, investors may
not see a dividend increase. By contrast, under
the constant dividend policy, a percentage of the
company's earnings are paid every year. In this
way, investors experience the full volatility of
company earnings. If earnings are up, investors
get a larger dividend; if earnings are down,
investors may not receive a dividend. The
primary drawback to the method is the volatility of
earnings and dividends. It is difficult to plan when
dividend income is highly volatile.
Residual Dividend Policy
A residual dividend policy is also highly volatile,
but for some investors, it is the only acceptable
dividend policy that a company should have. In a
residual dividend policy the company pays out
what's left after it pays for capital expenditures
and working capital needs. This approach is
volatile, but it makes the most sense in terms of
business operations. Investors don't want to
invest in a company that justifies its increased
debt with the need to pay dividends.
Dividend
A dividend is a distribution of a portion of a
company's earnings, decided by the board of
directors, to a class of its shareholders.
Dividends can be issued as cash payments, as
shares of stock, or other property.
BREAKING DOWN 'Dividend'
The dividend rate may be quoted in terms of the
dollar amount each share receives (dividends per
share, or DPS), or It can also be quoted in terms
of a percent of the current market price, which is
referred to as the dividend yield.
A company's net profits can be allocated
to shareholders via a dividend, or kept within the
company as retained earnings. A company may
also choose to use net profits to repurchase their
own shares in the open markets in a share
buyback. Dividends and share buy-backs do not
change the fundamental value of a company's
shares. Dividend payments must be approved by
the shareholders and may be structured as a
one-time special dividend, or as an ongoing cash
flow to owners and investors.
Mutual fund and ETF shareholders are often
entitled to receive accrued dividends as
well. Mutual funds pay out interest and dividend
income received from their portfolio holdings as
dividends to fund shareholders. In addition,
realized capital gains from the portfolio's trading
activities are generally paid out (capital gains
distribution) as a year-end dividend.
The dividend discount model, or Gordon growth
model, relies on anticipated future dividend
streams to value shares.
Companies That Issue
Dividends
Start-ups and other high-growth companies such
as those in the technology or biotechnology
sectors rarely offer dividends because all of their
profits are reinvested to help sustain higher-than-
average growth and expansion. Larger,
established companies tend to issue regular
dividends as they seek to maximize shareholder
wealth in ways aside from supernormal growth.
Companies in the following sectors and industries
have among the highest historical dividend
yields: basic materials, oil and gas, banks and
financial, healthcare and
pharmaceuticals, utilities, and REITS.
Arguments for Issuing
Dividends
The bird-in-hand argument for dividend policy
claims that investors are less certain of receiving
future growth and capital gains from the
reinvested retained earnings than they are of
receiving current (and therefore certain) dividend
payments. The main argument is that investors
place a higher value on a dollar of current
dividends that they are certain to receive than on
a dollar of expected capital gains, even if they are
theoretically equivalent.
In many countries, the income from dividends is
treated at a more favorable tax rate than ordinary
income. Investors seeking tax-advantaged cash
flows may look to dividend-paying stocks in order
to take advantage of potentially favorable
taxation. The clientele effect suggests especially
those investors and owners in high marginal tax
brackets will choose dividend-paying stocks.
If a company has a long history of past dividend
payments, reducing or eliminating the dividend
amount may signal to investors that the company
could be in trouble. An unexpected increase in
the dividend rate might be a positive signal to the
market.
Dividend Payout Policies
A company that issues dividends may choose the
amount to pay out using a number of methods.
Stable dividend policy: Even if corporate
earnings are in flux, stable dividend
policy focuses on maintaining a steady
dividend payout.
Target payout ratio: A stable dividend
policy could target a long-run dividend-to-
earnings ratio. The goal is to pay a stated
percentage of earnings, but the share
payout is given in a nominal dollar amount
that adjusts to its target at the earnings
baseline changes.
Constant payout ratio: A company pays
out a specific percentage of its earnings
each year as dividends, and the amount
of those dividends therefore vary directly
with earnings.
Residual dividend model: Dividends are
based on earnings less funds the
firm retains to finance the equity portion of
its capital budget and any residual profits
are then paid out to shareholders.
Dividend Irrelevance
Economists Merton
Miller and Franco Modigliani argued that a
company's dividend policy is irrelevant, and it has
no effect on the price of a firm's stock or its cost
of capital. Assume, for example, that you are a
stockholder of a firm and you don't like
its dividend policy. If the firm's cash dividend is
too big, you can just take the excess
cash received and use it to buy more of the firm's
stock. If the cash dividend you received was too
small, you can just sell a little bit of your existing
stock in the firm to get the cash flow you want. In
either case, the combination of the value of your
investment in the firm and your cash in hand will
be exactly the same. When they conclude that
dividends are irrelevant, they mean that investors
don't care about the firm's dividend policy
since they can create their own synthetically.
It should be noted that the dividend irrelevance
theory holds only in a perfect world with no taxes,
no brokerage costs, and infinitely divisible
shares.
Forward
Dividend Yield
A forward dividend yield is an estimation of a
year's dividend expressed as a percentage of
current stock price. The year's projected dividend
is measured by taking a stock's most recent
actual dividend payment and annualizing it.
Forward dividend yield is calculated by dividing a
year's worth of future dividend payments by a
stock's current share price.
BREAKING DOWN 'Forward
Dividend Yield'
For example, if a company pays a Q1 dividend of
25 cents and you assume the company's
dividend will be consistent, then the firm will be
expected to pay $1.00 in dividends over the
course of the year. If the stock price is $10, the
forward dividend yield is 10%.
The opposite of a forward dividend yield is
a trailing dividend yield, which shows a
company's actual dividend payments relative to
its share price over the previous 12 months.
When future dividend payments are not
predictable, trailing dividend yield can be a better
measure of value. When future dividend
payments are predictable or have been
announced, forward dividend yield is a more
accurate tool.
Dividend Rate
The dividend rate is the total amount of the
expected dividend payments from an investment,
fund or portfolio expressed on an annualized
basis plus any additional non-recurring dividends
that may be received during that period.
Depending on the company's preferences and
strategy, the dividend rate can be fixed or
adjustable.
BREAKING DOWN 'Dividend
Rate'
The dividend rate of an investment, fund or
portfolio is calculated by multiplying the most
recent periodic dividend payments by the number
of periods in one year. For example, if a fund of
investments pays a dividend of 50 cents on a
quarterly basis and pays an extra dividend of 12
cents per share because of a non-recurring event
from which the company benefited, the dividend
rate is $2.12 ($0.50 x 4 + $0.12) per year.
Dividends are generally paid out by companies
that generate stronger cash flows. Companies
that are growing rapidly typically reinvest any
cash generated back into the business, and they
don't pay out any dividends to shareholders.
Cash-intensive businesses like consumer staples
and utilities don't usually need to spend a lot
investing in growing their companies, so they can
distribute a percentage of income to shareholders
as dividends.
Dividend Payout Ratio
Companies that pay dividends often prefer to
maintain or slowly grow their dividend rates as a
demonstration of stability and as a means of
rewarding shareholders. Companies that cut their
dividends may be entering a financially weaker
state that, in many cases, is accompanied by a
drop in the stock price.
The dividend payout ratio is one way to assess
the strength of a company's dividend. It's
calculated as the dividend rate dividend by
earnings per share (EPS) over a 12-month time
period. Lower payout ratios are preferable, since
it means less of a company's net income is going
towards dividend payments. These dividends are
generally considered to be more sustainable.
Conversely, companies with high payout ratios
may have more trouble maintaining dividend
payments.
Dividend Aristocrats
Income-seeking investors often look to
companies with long histories of steadily growing
dividend payments. A dividend aristocrat is a
company that has raised its dividend for at least
25 straight years.
Dividend aristocrats typically come from sectors
that experience steady demand in different
economic environments. Companies engaged in
utility services, consumer goods and food
production are the most likely to have the means
to grow dividend rates continuously. As of May
31, 2016, a total of 108 companies meet the
dividend aristocrat definition. American States
Water Company (NYSE: AWR) is the longest-
tenured dividend aristocrat, with 61 consecutive
years of increased dividends.
Accelerated
Dividend
Special dividends paid by a company ahead of
an imminent change in the treatment of
dividends, such as an adverse change in
dividend taxation. Accelerated dividends from
U.S. companies came to the forefront in the
fourth quarter of 2012. During that period.
numerous companies expedited dividend
payments ahead of the January 1, 2013
expiration of the preferential 15% tax on dividend
income instituted by former President Bush in
2003. The concern was that as a consequence of
the fiscal cliff, the dividend tax rate could more
than double for taxpayers in the highest income
bracket.
BREAKING DOWN 'Accelerated
Dividend'
U.S. companies scrambled to pay accelerated
dividends in the fourth quarter of 2012, with total
special dividend announcements exceeding $31
billion, an increase of more than four times the
dividend payout made in the year-earlier period.
In November 2012 alone, 228 companies
announced special dividends, a more than three-
fold increase from the 72 companies that did so a
year earlier.
Many companies went to great lengths to
minimize the potential tax bill to their
shareholders. Some tactics included
consolidating future dividend payments into one
payout, and taking on debt to pay accelerated
dividends.
For example, the Washington Post accelerated
payment of all its 2013 dividends into one single
dividend payout made in December 2012.
Seaboard Corp accelerated its $3 annual
dividend for the 2013-2016 period and made a
single consolidated dividend payment on
December 28, 2012. Oracle accelerated its
dividend payments for the first three quarters of
2013, consolidating its quarterly dividend of 6
cents per share into one payment of 18 cents
paid on December 21, 2012. Oracle CEO Larry
Ellison, who owned 1.1 billion Oracle shares at
the time, received close to $200 million from the
accelerated dividend payment, saving over $50
million in federal income taxes. Costco paid out a
special dividend of $7 per share for a total of $3
billion, and funded it by taking on $3.5 billion in
debt.
Fears that the tax rate on dividends could soar
from 15% to over 40% for high-income taxpayers
subsequently proved to be unfounded. Thanks to
the last-minute fiscal cliff deal signed in January
2013, the top marginal tax rate on dividend
income was set at 20% for taxpayers with
adjusted gross income of $200,000 or more (the
threshold is $250,000 if married and filing jointly).
Indicated Yield
The dividend yield that a share of stock would
return based on its current indicated dividend.
Indicated yield is calculated by dividing the most
recent dividend multiplied by the number of
dividend payments each year (the indicated
dividend) by the current share price, and is
usually quoted as a percentage:
Stock ABC's most recent quarterly dividend, for
example, might be $4. If the stock is currently
trading at $100, the indicated yield would be:
Indicated Yield of Stock ABC = $4 X 4 / $100 =
16%
A dividend is a distribution of a portion of a
company's earnings, usually quoted in terms of
the dollar amount each share receives (such as
25 cents per share). The indicated yield is often
used as a forecasting technique to estimate a
stock's annual dividend yield or the
yearly earnings investors can expect for a
particular stock. Many stock tables included in
financial newspapers, such as the Wall Street
Journal, include the indicated dividend of each
stock to alert investors to the annual cash returns
they might be able to expect. Because common
stock dividends can change, instead of remain
constant, (stockholders may receive larger
dividends if earnings rise or smaller dividends if
earnings drop, for example) the indicated yield is
an estimate only.
Interim Dividend
An interim dividend is a dividend payment made
before a company's AGM and final financial
statements. This declared dividend usually
accompanies the company's interim financial
statements. This is used more frequently in the
United Kingdom, where it is usual for dividend
payments to occur semi-annually. The interim
dividend is generally the smaller of the two
payments made to shareholders.
BREAKING DOWN 'Interim
Dividend'
There are two main ways that investors can
invest in a company, through bonds or stocks.
Bonds pay a set rate of interest, and investors
have seniority over shareholders in case of
bankruptcy, but they don't give investors the
ability to participate in share price appreciation.
Stocks don't pay interest, but some do pay
dividends. Dividends also allow shareholders to
benefit from earnings growth through both interim
and final dividends as well as share price
appreciation. An interim dividend is declared by
directors and subject to shareholder approval. By
contrast, a normal, or final dividend is voted on
and approved at the annual general meeting
(AGM) once earnings are known. Both interim
and regular, or final, dividends can be paid out in
cash and/or stock.
Final vs. Interim Dividends
Dividends are paid out per share owned. For
example, if you own 100 shares of company A,
and company A pays out $1 in dividends every
year, you will receive $100 in dividend income
every year. If company A doubles their dividend it
means they will pay out $2 per share and you will
get $200 annually. Final dividends are
announced and paid out on an annual basis
along with earnings. That is, final or regular
dividends are announced after earnings are
determined. Interim dividends, however, are paid
out of retained earnings, not current earnings.
Retained earnings can also be thought of as
undistributed profits. As such, these dividends
are generally paid on a quarterly or six-month
basis, prior to the end of the year. Interim
dividends are paid every six months in the UK,
and every three months in the United States.
Companies generally declare and distribute an
interim dividend during an exceptional earnings
season or when legislation makes it more
advantageous to do so.
A final or regular dividend can be a set amount
every quarter, six months, or a year. It can be a
percentage of net income or earnings. It can also
be paid out of the earnings leftover after the
company pays for capital expenditures and
working capital. The dividend policy or strategy
used is dependent on management's goals and
intentions for shareholders. Interim dividends can
follow the same strategy as final dividends, but
since interim dividends are paid out before the
end of the fiscal year the financial statements that
accompany interim dividends are unaudited.
Residual Dividend
A residual dividend is a dividend policy company
management uses to fund capital expenditures
with available earnings before paying dividends
to shareholders, and this policy creates
more volatility in the dollar amount of dividends
paid to investors each year. The first priority is to
use earnings to cash flow capital expenditures,
and dividends are paid with any remaining
earnings generated by the firm.
BREAKING DOWN 'Residual
Dividend'
A companys capital structure typically includes
both long-term debt and equity, and a capital
expenditure can be financed by taking out a loan
or by issuing more stock.

How Companies Use Earnings
When a business generates earnings, the firm
can either retain the earnings for use in the
company or pay the earnings as a dividend to
stockholders, and retained earnings are used to
fund current business operations or to buy
assets. Every company needs assets to operate,
and those assets may need to be upgraded over
time and eventually replaced. Business
managers must consider the assets needed to
operate the business and the need to reward
shareholders by paying a dividend.
Factoring in Residual Dividends
Assume that a clothing manufacturer maintains a
list of capital expenditures that are required in
future years and that the firm needs $100,000 in
the current month to upgrade machinery and buy
a new piece of equipment. The firm generates
$140,000 in earnings for the month and spends
$100,000 on capital expenditures. The remaining
income of $40,000 is paid as a residual dividend
to shareholders, which is $20,000 less than was
paid in each of the last three months.
Shareholders may be upset when management
chooses to lower the dividend payment, and
senior management needs to explain the
importance of capital spending to justify the lower
payment.
Examples of Return on Assets
While shareholders may accept managements
strategy of using earnings for capital
expenditures, the investment community
analyzes how well the firm uses asset spending
to generate more income. The return on asset
(ROA) formula is net income divided by total
assets, and ROA is a common tool used to
assess managements performance. If the
clothing manufacturer makes smart spending
decision with the $100,000, the company can
increase production or operate machinery at a
lower cost, and both of these factors can increase
profits. As net income increases, the ROA ratio
improves, and shareholders may be more willing
to accept the residual dividend policy moving
forward. However, if the firm generates lower
earnings and continues to fund capital
expenditures at the same rate, shareholder
dividends decline.
Accumulated
Dividend
A dividend on a share of cumulative preferred
stock that has not yet been paid to
the shareholder. Accumulated dividends are the
result of dividends that are carried forward from
previous periods and shareholders of cumulative
preferred stock receive dividends before any
other shareholders.
BREAKING DOWN
'Accumulated Dividend'
Preferred stock can either be "non-cumulative",
which is traditionally the case or "cumulative"
when it comes to dividends. Non-cumulative
shares are entitled to dividends only if dividends
are declared. Some investors may want a
guaranteed return on a preferred stock. A
cumulative preferred stock allows the investor to
earn dividends regardless of the
company's ability to pay them immediately or in
the future. In some instances, when some
companies are not in a financial position to pay
a dividend during a certain year, accumulated
dividends are created. These dividends must be
paid before any other dividends can be paid.
Constructive
Dividend
A concept in U.S. taxation in which
various distributions to shareholders are not
labeled as dividends but are still considered
dividends by the IRS and taxed as such.
Constructive dividends are most commonly found
in companies in which the employees are also
the shareholders. You can think of a
constructive dividend as an undeclared dividend
by the company that involves the use of
corporate assets.
BREAKING DOWN
'Constructive Dividend'
For example, in many small companies,
employees who are also shareholders may
borrow money from the company to buy personal
items. This loan may be classified by the IRS as
a constructive dividend and must be reported on
the tax return of the shareholder. In addition, the
company would not be able to take
a deduction for the constructive dividend.
Funadmaental analysis
It is a quatittavi and cualitative view. Introduce the
subject of intrisic value adn conclude with some
of the downfalls of using this tcnique.
It attemps to detemrine a security's value by
focusing on underlying factors that affect a
company's actual business and its future
prospects. On a broader scope, you can
perform fundamental analysis on industries or
the economy as a whole.
fundamelta viw-refers to the analysis of the
economic well-being of a financial entity as
opposed to only its price movements.
Fundamental analysis serves to answer
questions, such as:
Is the company's revenue growing?
Revenue
Is it actually making a profit? profit
Is it in a strong-enough position to beat
out its competitors in the future?
Beat competitors in the future
Is it able to repay its debts? liquidity
and solvence in debts.
Is management trying to "cook the
books"?managmente
: Is the company's stock a good investment?
Think of FA as a toolbox to help you answer
this question.
Note: The term fundamental analysis is used
most often in the context of stocks, but you can
perform fundamental analysis on any security,
from a bond to a derivative. As long as you
look at the economic fundamentals, you are
doing fundamental analysis.
Fundamentals: Quantitative and Qualitative
You could define fundamental analysis as
"researching the fundamentals", but that
doesn't tell you a whole lot unless you know
what fundamentals are. As we mentioned in the
introduction, the big problem with defining
fundamentals is that it can include anything
related to the economic well-being of a
company. Obvious items include things like
revenue and profit, but fundamentals also
include everything from a company's market
share to the quality of its management.
The various fundamental factors can be
grouped into two categories: quantitative and
qualitative. The financial meaning of these terms
isn't all that different from their regular definitions.
Here is how the MSN Encarta dictionary defines
the terms:
Quantitative capable of being
measured or expressed in numerical
terms characteristics of the
Qualitative related to or based on the
quality or character of something, often
as opposed to its size or quantity.
In our context, quantitative fundamentals are
numeric, measurable characteristics about a
business. Quntitative methods are more with
great precision.
Turning to qualitative fundamentals, these are
the less tangible factors surrounding a
business - things such as the quality of a
company's board members and key
executives, its brand-name
recognition, patents or proprietary
technology.
Quantitative Meets Qualitative
Neither qualitative nor quantitative analysis is
inherently better than the other. Instead, many
analysts consider qualitative factors in
conjunction with the hard, quantitative
factors. Take the Coca-Cola Company, for
example. When examining its stock, an analyst
might look at the stock's annual dividend
payout, earnings per share, P/E ratio and
many other quantitative factors. However, no
analysis of Coca-Cola would be complete
without taking into account its brand
recognition,but few companies on earth are
recognized by billions of people. It's tough to
put your finger on exactly what the Coke brand
is worth, but you can be sure that it's an
essential ingredient contributing to the
company's ongoing success.
The Concept of Intrinsic Value
Asumptions:
I). the price on the stock market does not fully
reflect a stock's "real" value. In financial
jargon, this true value is known as the intrinsic
value.
II)In the long run, the stock market will reflect
the fundamentals. There is no point in buying a
stock based on intrinsic value if the price
never reflected that value. Nobody knows how
long "the long run" really is. It could be days
or years.
By focusing on a particular business, an
investor can estimate the intrinsic value of a
firm and thus find opportunities where to buy
at a discount. If all goes well, the investment will
pay off over time as the market catches up to
the fundamentals.
The big unknowns are:
1)You don't know if your estimate of intrinsic
value is correct; and
2)You don't know how long it will take for the
intrinsic value to be reflected in the
marketplace.
Criticisms of Fundamental Analysis
The biggest criticisms from two groups:
proponents of technical analysis and believers of
the "efficient market hypothesis".
1)Technical analysis is the other major form of
security analysis.
Put simply, technical analysts base their
investments (or, more precisely, their trades)
solely on the price and volume movements of
securities. Using charts and a number of other
tools, they trade on momentum, not caring
about the fundamentals.
tenets of technical analysis is that the market
discounts everything. Accordingly, all news
about a company already is priced into a
stock, and therefore a stock's price
movements give more insight than the
underlying fundamental factors of the
business itself.
2)Followers of the efficient market hypothesis,
however, are usually in disagreement with
both fundamental and technical analysts. The
efficient market hypothesis contends that it is
essentially impossible to produce market-
beating returns in the long run, through either
fundamental or technical analysis. The
rationale for this argument is that, since the
market efficiently prices all stocks on an
ongoing basis, any opportunities for excess
returns derived from fundamental (or technical)
analysis would be almost immediately
(reducidas)whittled away by the market's
many participants, making it impossible for
anyone to meaningfully outperform the market
over the long term.
Fundamental Analysis: Qualitative
Factors - The Company
1)Qualitative factors
represent aspects of a company's business that
are difficult or impossible to quantify,
incorporating that kind of information into a
pricing evaluation can be quite difficult. 4 factors
inuqlitative.
Business Model
Competitive Advantage
Management
Corporate gobvernance
I)Business Model
Even before an investor looks at a company's
financial statements or does any research,
os important What exactly does the
company do? This is referred to as a
company's business model it's how a
company makes money. You can get a good
overview of a company's business model by
checking out its website or reading the first
part of its 10-K filing
Sometimes business models are easy to
understand. Other times, you'd be surprised how
complicated it can get. Boston Chicken Inc. is a
prime example of this. Back in the early '90s its
stock was the darling of Wall Street. At one
point the company's CEO bragged that they were
the "first new fast-food restaurant to reach $1
billion in sales since 1969". The problem is, they
didn't make money by selling chicken. Rather,
they made their money from royalty fees and
high-interest loans to franchisees. Boston
Chicken was really nothing more than a big
franchisor. On top of this, management was
aggressive with how it recognized its revenue. As
soon as it was revealed that all the franchisees
were losing money, the house of cards
collapsed and the company went bankrupt.
At the very least, you should understand the
business model of any company you invest in.
Competitive Advantage
A company's long-term success is driven
largely by its ability to maintain a competitive
advantage - and keep it. Powerful competitive
advantages, such as Coca Cola's brand name,
create a moat around a business allowing it to
keep competitors at bay and enjoy growth
and profits. When a company can achieve
competitive advantage, its shareholders can
be well rewarded for decades.
Michael Porter, distinguishes between strategic
positioning and operational effectiveness.
Operational effectiveness means a company is
better than rivals at similar activities while
competitive advantage means a company is
performing better than rivals by doing
different activities or performing similar
activities in different ways. Investors should
know that few companies are able to compete
successfully for long if they are doing the
same things as their competitors.
Professor Porter argues that, in general,
sustainable competitive advantage gained by:
A unique
competitive position
Clear tradeoffs and choices vis--vis
competitors
Activities tailored to the company\'s
strategy
A high degree of fit across activities (it
is the activity system, not the parts,
that ensure sustainability)
II)Management
Some believe that management is the most
important aspect for investing in a company. It
makes sense - even the best business model
is doomed if the leaders of the company fail to
properly execute the plan.
So how does an average investor go about
evaluating the management of a company?
You can't set up a meeting with management if
you want to invest a few thousand dollars. On
the other hand, if you are a fund manager
interested in investing millions of dollars,
there is a good chance you can schedule a
face-to-face meeting with the upper brass of
the firm.
Every public company has a corporate
information section on its website. Don't expect
to find anything useful here.
Instead, here are a few ways for you to get a
feel for management:
1. Conference Calls
The Chief Executive Officer (CEO) and Chief
Financial Officer (CFO) host quarterly
conference calls. (Sometimes you'll get other
executives as well.) The first portion of the call
is management basically reading off the
financial results. What is really interesting is
the question-and-answer portion of the call.
This is when the line is open for analysts to call
in and ask management direct questions.
Answers here can be revealing about the
company, but more importantly, listen for candor.
Do they avoid questions, like politicians, or do
they provide forthright answers?
2. Management Discussion and Analysis
(MD&A)
The Management Discussion and Analysis is
found at the beginning of the annual report.
One tip is to compare what management said
in past years with what they are saying now.
Is it the same material rehashed? Have strategies
actually been implemented? If possible, sit
down and read the last five years of MD&As;
it can be illuminating.
3. Ownership and Insider Sales
Just about any large company will
compensate executives with a combination of
cash, restricted stock and options. While there
are problems with stock options), it is a positive
sign that members of management are also
shareholders. The ideal situation is when the
founder of the company is still in charge. When
you know that a majority of management's wealth
is in the stock, you can have confidence that
they will do the right thing. As well, it's worth
checking out if management has been selling its
stock. This has to be filed with the Securities and
Exchange Commission (SEC), so it's publicly
available information. Talk is cheap - think twice if
you see management unloading all of its shares
while saying something else in the media.
4. Past Performance
Another good way to get a feel for management
capability is to check and see how executives
have done at other companies in the past.
III)Corporate Governance
Corporate governance describes the policies in
place within an organization denoting the
relationships and responsibilities between
management, directors and stakeholders.
These policies are defined and determined in
the company charter and its bylaws, along
with corporate laws and regulations. The
purpose of corporate governance policies is to
ensure that proper checks and balances are
in place, making it more difficult for anyone to
conduct unethical and illegal activities.
Good corporate governance is a situation in
which a company complies with all of its
governance policies and applicable
government regulations
Although, there are companies and organizations
(such as Standard & Poor's) that attempt
to quantitatively assess companies on how
well their corporate governance policies
serve stakeholders, most of these reports are
quite expensive for the average investor to
purchase.
Fortunately, corporate governance policies
typically cover a few general areas: structure
of the board of directors, stakeholder rights
and financial and information transparency.
With a little research and the right questions in
mind, investors can get a good idea about a
company's corporate governance.
Financial and Information Transparency
This aspect of governance relates to the
quality and timeliness of a company's
financial disclosures and operational
happenings. Sufficient transparency implies
that a company's financial releases are
written in a manner that stakeholders can
follow what management is doing and
therefore have a clear understanding of the
company's current financial situation.
Stakeholder Rights
This aspect of corporate governance examines
the extent that a company's policies are
benefiting stakeholder interests, notably
shareholder interests. Ultimately, as owners of
the company, shareholders should have some
access to the board of directors if they have
concerns or want something addressed.
Therefore companies with good governance give
shareholders a certain amount of ownership
voting rights to call meetings to discuss pressing
issues with the board.
Another relevant area for good governance, in
terms of ownership rights, is whether or not a
company possesses large amounts of takeover
defenses (such as the Macaroni Defense or
the Poison Pill) or other measures that make it
difficult for changes in management, directors
and ownership to occur.
Structure of the Board of Directors
The board of directors is composed of
representatives from the company and
representatives from outside of the company.
The combination of inside and outside directors
attempts to provide an independent
assessment of management's performance,
making sure that the interests of shareholders
are represented.
The key word when looking at the board of
directors is independence. The board of
directors is responsible for protecting
shareholder interests and ensuring that the
upper management of the company is doing
the same. The board possesses the right to
hire and fire members of the board on behalf
of the shareholders. A board filled
with insiders will often not serve as objective
critics of management and will defend their
actions as good and beneficial, regardless of
the circumstances.
1. Fundamental Analysis: Qualitative Factors
- The Industry
We've now gone over the business model,
management and corporate governance.
These three areas are all important to consider
when analyzing any company. We will now
move on to looking at qualitative factors in
the environment in which the company
operates.
Each industry has differences in terms of its
customer base, market share among firms,
industry-wide growth, competition, regulation
and business cycles. Learning about how the
industry works will give an investor a deeper
understanding of a company's financial
health.
I)Customers
Some companies serve only a handful of
customers, while others serve millions. In
general, it's a red flag (a negative) if a business
relies on a small number of customers for a
large portion of its sales because the loss of
each customer could dramatically affect
revenues. For example, think of a military
supplier who has 100% of its sales with
the U.S. government.. For this reason,
companies will always disclose in their 10-K if
any one customer accounts for a majority of
revenues.
2)Market Share
Understanding a company's present market
share can tell volumes about the company's
business. The fact that a company possesses
an 85% market share tells you that it is the
largest player in its market by far. Furthermore,
this could also suggest that the company
possesses some sort of "economic moat," in
other words, a competitive barrier serving to
protect its current and future earnings, along
with its market share. Market share is important
because of economies of scale. When the firm
is bigger than the rest of its rivals, it is in a better
position to absorb the high fixed costs of a
capital-intensive industry.
Industry Growth
One way of examining a company's growth
potential is to first examine whether the amount
of customers in the overall market will grow.
This is crucial because without new customers,
a company has to steal market share in order
to grow.
Competition
Simply looking at the number of competitors
goes a long way in understanding the
competitive landscape for a company.
Industries that have limited barriers to
entry and a large number of competing firms
create a difficult operating environment for
firms.
One of the biggest risks within a highly
competitive industry is pricing power. This
refers to the ability of a supplier to increase
prices and pass those costs on to customers.
Companies operating in industries with few
alternatives have the ability to pass on costs
to their customers
Regulation
Certain industries are heavily regulated due to
the importance or severity of the industry's
products and/or services. As important as
some of these regulations are to the public,
they can drastically affect the attractiveness
of a company for investment purposes.
In industries where one or two companies
represent the entire industry for a region
(such as utility companies), governments
usually specify how much profit each
company can make. In these instances, while
there is the potential for sizable profits, they are
limited due to regulation.
In other industries, regulation can play a less
direct role in affecting industry pricing.
All in all, investors should always be on the
lookout for regulations that could potentially
have a material impact upon a business'
bottom line.
Fundamental Analysis:
Introduction to Financial
Statements
gold o mine f you know how to intepret and
analyze.

Financial statements are the medium by which
a company discloses information concerning
its financial performance. Followers
of fundamental analysis use
the quantitative information gleaned from
financial statements to make investment
decisions. Before we jump into the specifics of
the three most important financial statements
- income statements, balance
sheets and cash flow statements
The Major Statements
The Balance Sheet
The balance sheet represents a record of a
company's assets, liabilities and equity at a
particular point in time. The balance sheet is
named by the fact that a business's financial
structure balances in the following manner:
Assets = Liabilities + Shareholders\' Equity
Assets represent the resources that the
business owns or controls at a given point in
time. This includes items such as cash,
inventory, machinery and buildings. The other
side of the equation represents the total value of
the financing the company has used to
acquire those assets. Financing comes as a
result of liabilities or equity. Liabilities
represent debt while equity represents the
total value of money that the owners have
contributed to the business - including retained
earnings, which is the profit made in previous
years.
The Income Statement
While the balance sheet takes a snapshot
approach in examining a business, the
income statement measures a company's
performance over a specific time frame.
Technically, you could have a balance sheet for a
month or even a day, but you'll only see public
companies report quarterly and annually.
The income statement presents information
about revenues, expenses and profit that was
generated as a result of the business'
operations for that period.
Statement of Cash Flows
The statement of cash flows represents a
record of a business' cash inflows and
outflows over a period of time. Typically, a
statement of cash flows focuses on the following
cash-related activities:
Operating Cash Flow (OCF): Cash
generated from day-to-
day business operations
Cash from investing (CFI): Cash used for
investing in assets, as well as the
proceeds from the sale of other
businesses, equipment or long-term
assets
Cash from financing (CFF): Cash paid or
received from the issuing and
borrowing of funds
The cash flow statement is important because
it's very difficult for a business to manipulate
its cash situation. There is plenty that
aggressive accountants can do to manipulate
earnings, but it's tough to fake cash in the
bank. For this reason some investors use the
cash flow statement as a more conservative
measure of a company's performance.
10-K and 10-Q
Now that you have an understanding of what the
three financial statements represent, let's
discuss where an investor can go about
finding them. In the United States, the Securities
And Exchange Commission (SEC) requires all
companies that are publicly traded on a major
exchange to submit periodic filings detailing
their financial activities, including the
financial statements mentioned above.
Some other pieces of information that are also
required are an auditor's report, management
discussion and analysis (MD&A) and a relatively
detailed description of the company's
operations and prospects for the upcoming year.
All of this information can be found in the
business' annual 10-K and quarterly 10-
Q filings, which are released by the
company's management and can be found on
the internet or in physical form.
The 10-K is an annual filing that discloses a
business's performance over the course of
the fiscal year. In addition to finding a business's
financial statements for the most recent year,
investors also have access to the business's
historical financial measures, along with
information detailing the operations of the
business. This includes a lot of information, such
as the number of employees, biographies of
upper management, risks, future plans for
growth, etc.
Businesses also release an annual report,
which some people also refer to as the 10-K.
The annual report is essentially the 10-K
released in a fancier marketing format. It will
include much of the same information, but not
all, that you can find in the 10-K. The 10-K
really is boring - it's just pages and pages of
numbers, text and legalese. But just because
it's boring doesn't mean it isn't useful. There
is a lot of good information in a 10-K, and it's
required reading for any serious investor.
You can think of the 10-Q filing as a smaller
version of a 10-K. It reports the company's
performance after each fiscal quarter. Each
year three 10-Q filings are released - one for
each of the first three quarters.). Unlike the 10-
K filing, 10-Q filings are not required to be
audited. Here's a tip if you have trouble
remembering which is which: think "Q" for
quarter.
Fundamental Analysis: Other
Important Sections Found in
Financial Filings
The financial statements are not the only parts
found in a business's annual and quarterly
SEC filings. Here are some other noteworthy
sections:
Management Discussion and Analysis
(MD&A)
As a preface to the financial statements, a
company's management will typically spend a
few pages talking about the recent year (or
quarter) and provide background on the
company.). In addition to providing investors a
clearer picture of what the company does, the
MD&A also points out some key areas in
which the company has performed well.
Don't expect the letter from management to delve
into all the juicy details affecting the company's
performance. The management's analysis is at
their discretion, so understand they probably
aren't going to be disclosing any negatives.
Here are some things to look out for:
How candid and accurate are
management's comments?
Does management discuss significant
financial trends over the past couple
years? (compare the MD&As over the
last few years to see how the message
has changed and whether management
actually followed through with its plan.)
How clear are management's comments?
If executives try to confuse you with big
words and jargon, perhaps they have
something to hide.
Do they mention potential risks or
uncertainties moving forward?
Disclosure is the name of the game. If a
company gives a decent amount of
information in the MD&A, it's likely that
management is being upfront and honest.
The Auditor's Report
The auditors' job is to express an opinion on
whether the financial statements are
reasonably accurate and provide adequate
disclosure. This is the purpose behind
the auditor's report, which is sometimes called
the "report of independent accountants".
By law, every public company that trades
stocks or bonds on an exchange must have
its annual reports audited by a certified public
accountants firm. An auditor's report is meant
to scrutinize the company and identify
anything that might undermine the integrity of
the financial statements.
The typical auditor's report is almost always
broken into three paragraphs and written in
the following fashion:
Independent Auditor\'s Report
Paragraph 1
Recounts the responsibilities of the auditor
and directors in general and lists the areas of
the financial statements that were audited.
Paragraph 2
Lists how the generally accepted accounting
principles (GAAP) were applied, and what
areas of the company were assessed.
Paragraph 3
Provides the auditor\'s opinion on the financial
statements of the company being audited. This
is simply an opinion, not a guarantee of
accuracy.
While the auditor's report won't uncover any
financial bombshells, audits give credibility to
the figures reported by management. You'll
only see unaudited financials for unlisted
firms.While quarterly statements aren't
audited, you should be very wary of any
annual financials that haven't been given the
accountants' stamp of approval.
The Notes to the Financial Statements
Just as the MD&A serves an introduction to
the financial statements, the notes to
the financial statemen tie up any loose ends
and complete the overall picture. If
the income statement, balance sheet
and statement of cash flows are the heart of
the financial statements, then the footnotes are
the arteries that keep everything connected.
Therefore, if you aren't reading the footnotes,
you're missing out on a lot of information.
The footnotes list important information that
could not be included in the actual ledgers.
For example, they list relevant things like
outstanding leases, the maturity dates of
outstanding debt and details on compensation
plans, such as stock options, etc.
Generally speaking there are two types of
footnotes:
Accounting Methods - This type of footnote
identifies and explains the major accounting
policies of the business that the company
feels that you should be aware of. This is
especially important if a company has changed
accounting policies. It may be that a firm is
practicing "cookie jar accounting" and is
changing policies only to take advantage of
current conditions in order to hide poor
performance.
Disclosure - The second type of footnote
provides additional disclosure that simply
could not be put in the financial statements.
To maintain this cleanliness, other calculations
are left for the footnotes. For example, details of
long-term debt - such as maturity dates and
the interest rates at which debt was issued -
can give you a better idea of how borrowing
costs are laid out. Other areas of disclosure
include everything from pension plan liabilities
for existing employees to details about
ominous legal proceedings involving the
company.
The majority of investors and analysts read the
balance sheet, income statement and cash
flow statement but, for whatever reason, the
footnotes are often ignored. What sets
informed investors apart is digging deeper and
looking for information that others typically
wouldn't. No matter how boring it might be,
read the fine print - it will make you a better
investor.
7. Fundamental Analysis: The Income Statement
The income statement is basically the first
financial statement you will come across in an
annual report or quarterly Securities And
Exchange Commission (SEC) filing.
It also contains the numbers most often
discussed when a company announces
its results - numbers such
as revenue, earnings and earnings per share.
Basically, the income statement shows how
much money the company generated
(revenue), how much it spent (expenses) and
the difference between the two (profit) over a
certain time period.
When it comes to analyzing fundamentals, the
income statement lets investors know how
well the company's business is performing -
or, basically, whether or not the company is
making money.. Those companies with low
expenses relative to revenue - or high profits
relative to revenue - signal strong
fundamentals to investors.
Revenue as an investor signal
Revenue, also commonly known as sales, is
generally the most straightforward part of the
income statement..

The best way for a company to improve
profitability is by increasing sales revenue..
The best revenue are those that continue year
in and year out. Temporary increases, such as
those that might result from a short-term
promotion, are less valuable and should garner
a lower price-to-earnings multiple for a
company.
What are the Expenses?
There are many kinds of expenses, but the
two most common are:1) the cost of goods
sold (COGS) and 2)selling, general and
administrative expenses (SG&A). Cost of
goods sold is the expense most directly
involved in creating revenue. It represents the
costs of producing or purchasing the goods or
services sold by the company.
2)Next, costs involved in operating the
business are SG&A. This category includes
marketing, salaries, utility bills, technology
expenses and other general costs associated
with running a business. SG&A also
includes depreciation and amortization.
Companies must include the cost of replacing
worn out assets. Remember, some corporate
expenses, such as research and
development (R&D) at technology companies,
are crucial to future growth and should not be
cut, even though doing so may make for a better-
looking earnings report.
Finally, there are financial costs, notably
taxes and interest payments, which need to
be considered.
Profits = Revenue - Expenses
However, there are several commonly used profit
subcategories that tell investors how the
company is performing. Gross profit is
calculated as revenue minus cost of sales.
Companies with high gross margins will have
a lot of money left over to spend on other
business operations, such as R&D or
marketing.. This is a telltale sign of future
problems facing the bottom line. When cost
of goods sold rises rapidly, they are likely to
lower gross profit margins - unless, of course,
the company can pass these costs onto
customers in the form of higher prices.
Operating profit is equal to revenues minus the
cost of sales and SG&A. This number
represents the profit a company made from its
actual operations, and excludes certain
expenses and revenues that may not be
related to its central operations. High
operating margins can mean the company has
effective control of costs, or that sales are
increasing faster than operating costs.
Operating profit also gives investors an
opportunity to do profit-margin comparisons
between companies that do not issue a
separate disclosure of their cost of goods sold
figures (which are needed to do gross margin
analysis). Operating profit measures how much
cash the business throws off, and some
consider it a more reliable measure of
profitability since it is harder to manipulate
with accounting tricks than net earnings.
Net income generally represents the
company's profit after all expenses, including
financial expenses, have been paid. This
number is often called the "bottom line" and is
generally the figure people refer to when they
 use the word "profit" or "earnings".
When a company has a high profit margin, it
usually means that it also has one or more
advantages over its competition. Companies
with high net profit margins have a bigger
cushion to protect themselves during the hard
times. Companies with low profit margins can
get wiped out in a downturn. And companies
with profit margins reflecting a competitive
advantage are able to improve their market
share during the hard times - leaving them
even better positioned when things improve
again.
Conclusion
You can gain valuable insights about a
company by examining its income statement.
Increasing sales offers the first sign of strong
fundamentals. Rising margins indicate
increasing efficiency and profitability. It's also
a good idea to determine whether the company
is performing in line with industry peers and
competitors. Look for significant changes in
revenues, costs of goods sold and SG&A to
get a sense of the company's profit
fundamentals.
1. Fundamental Analysis: The Balance
Sheet
Investors often overlook the balance sheet.
Assets and liabilities aren't nearly as sexy
as revenue and earnings. While earnings are
important, they don't tell the whole story.
The balance sheet highlights the financial
condition of a company and is an integral part
of the financial statements.
The Snapshot of Health
It tells you how much a company owns (its
assets), and how much it owes (its liabilities).
The difference between what it owns and what
it owes is its equity, also commonly called
"net assets" or "shareholders equity".
The balance sheet tells investors a lot about a
company's fundamentals:
-how much debt the company has,
-how much it needs to collect from customers
(and how fast it does so),
- how much cash and equivalents it possesses
and
-what kinds of funds the company has
generated over time.
2. The Balance Sheet's Main Three
Assets, liability and equity are the three main
components of the balance sheet.
Assets
There are two main types of assets: current
assets and non-current assets. Current assets
are likely to be used up or converted into cash
within one business cycle - usually treated as
twelve months. Three very important current
asset items found on the balance sheet
are: cash, inventories and accounts
receivables.
Investors normally are attracted to companies
with plenty of cash on their balance sheets.
After all, cash offers protection against tough
times, and it also gives companies more
options for future growth. Growing cash
reserves often signal strong company
performance. Indeed, it shows that cash is
accumulating so quickly that management
doesn't have time to figure out how to make
use of it. A dwindling cash pile could be a sign
of trouble. That said, if loads of cash are more
or less a permanent feature of the company's
balance sheet, investors need to ask why the
money is not being put to use. Cash could be
there because management has run out of
investment opportunities or is too short-
sighted to know what to do with the money.
Inventories are finished products that haven't
yet sold. As an investor, you want to know if a
company has too much money tied up in its
inventory. Companies have limited funds
available to invest in inventory. To generate
the cash to pay bills and return a profit, they
must sell the merchandise they have
purchased from suppliers. Inventory
turnover (cost of goods sold divided by
average inventory) measures how quickly the
company is moving merchandise through the
warehouse to customers. If inventory grows
faster than sales, it is almost always a sign of
deteriorating fundamentals.
Receivables are outstanding (uncollected
bills). Analyzing the speed at which a company
collects what it's owed can tell you a lot about
its financial efficiency. If a company's
collection period is growing longer, it could
mean problems ahead. The company may be
letting customers stretch their credit in order
to recognize greater top-line sales and that can
spell trouble later on, especially if customers
face a cash crunch. Getting money right away
is preferable to waiting for it - since some of
what is owed may never get paid. The quicker
a company gets its customers to make
payments, the sooner it has cash to pay for
salaries, merchandise, equipment, loans, and
best of all, dividends and growth
opportunities.
Non-current assets are This includes items
that are fixed assets, such as property, plant
and equipment (PP&E). Unless the company
is in financial distress and
is liquidating assets, investors need not pay
too much attention to fixed assets. Since
companies are often unable to sell their fixed
assets within any reasonable amount of time
they are carried on the balance sheet at cost
regardless of their actual value. As a result,
it's is possible for companies to grossly
inflate this number, leaving investors with
questionable and hard-to-compare asset
figures.
Liabilities
There are current liabilities and non-current
liabilities. Current liabilities are obligations
the firm must pay within a year, such as
payments owing to suppliers. Non-current
liabilities, meanwhile, represent what the
company owes in a year or more time.
Typically, non-current liabilities represent bank
and bondholder debt.
You usually want to see a manageable amount
of debt. When debt levels are falling, that's a
good sign. Generally speaking, if a company
has more assets than liabilities, then it is in
decent condition. By contrast, a company with
a large amount of liabilities relative to assets
ought to be examined with more diligence.
Having too much debt relative to cash flows
required to pay for interest and debt
repayments is one way a company can
go bankrupt.

Look at the quick ratio. Subtract inventory
from current assets and then divide by
current liabilities. If the ratio is 1 or higher, it
says that the company has enough cash and
liquid assets to cover its short-term debt
obligations.
Current Assets - Inventories
Quick Ratio =
Current Liabilities
Equity
Equity represents what shareholders own, so it
is often called shareholder's equity. As
described above, equity is equal to total assets
minus total liabilities.
Equity = Total Assets Total Liabilities
The two important equity items are paid-in
capital and retained earnings. Paid-in capital
is the amount of money shareholders paid for
their shares when the stock was first
offered to the public. It basically represents
how much money the firm received when it
sold its shares. In other words, retained
earnings are a tally of the money the company
has chosen to reinvest in the business rather
than pay to shareholders. Investors should look
closely at how a company puts retained
capital to use and how a company generates
a return on it.
Most of the information about debt can be found
on the balance sheet - but some assets and
debt obligations are not disclosed there. For
starters, companies often possess hard-to-
measure intangible assets. Corporate
intellectual property (items such
as patents, trademarks, copyrights and
business methodologies), goodwill and brand
recognition are all common assets in today's
marketplace. But they are not listed on
company's balance sheets.
There is also off-balance sheet debt to be
aware of. This is form of financing in which
large capital expenditures are kept off of a
company's balance sheet through various
classification methods. Companies will often use
off-balance-sheet financing to keep the debt
levels low.
9)Fundamental Analysis: The Cash Flow
Statement
The cash flow statement shows how much cash
comes in and goes out of the company over
the quartera or the year.
What distinguishes the two is accrual
accounting, which is found on the income
statement. Accrual accounting requires
companies to
ecord revenues and expenses when
transactions occur, not when cash is
exchanged. At the same time, the income
statement, on the other hand, often includes
non-cash revenues or expenses, which the
statement of cash flows does not include.
Whereas when the bottom of the cash flow
statement reads $10 net cash inflow, that's
exactly what it means. The company has $10
more in cash than at the end of the last
financial period. You may want to think of net
cash from operations as the company's "true"
cash profit.
Because it shows how much actual cash a
company has generated, the statement of
cash flows is critical to understanding a
company's fundamentals. It shows how the
company is able to pay for its operations and
future growth.
Indeed, one of the most important features
you should look for in a potential investment is
the company's ability to produce cash. Just
because a company shows a profit on the
income statement doesn't mean it cannot get
into trouble later because of insufficient cash
flows. A close examination of the cash flow
statement can give investors a better sense of
how the company will fare.
Three Sections of the Cash Flow Statement
Companies produce and consume cash in
different ways, so the cash flow statement is
divided into three sections: cash flows from
operations, financing and investing. Basically,
the sections on operations and financing show
how the company gets its cash, while the
investing section shows how the company
spends its cash.
Cash Flows from Operating Activities
This section shows how much cash comes
from sales of the company's goods and
services, less the amount of cash needed to
make and sell those goods and services.
Investors tend to prefer companies that
produce a net positive cash flow from
operating activities. High growth companies,
such as technology firms, tend to show negative
cash flow from operations in their formative
years. At the same time, changes in cash flow
from operations typically offer a preview of
changes in net future income. Normally it's a
good sign when it goes up. Watch out for a
widening gap between a company's reported
earnings and its cash flow from operating
activities. If net income is much higher than
cash flow, the company may be speeding or
slowing its booking of income or costs.
Cash Flows from Investing Activities
This section largely reflects the amount of cash
the company has spent on capital
expenditures, such as new equipment or
anything else that needed to keep the
business going. It also includes acquisitions
of other businesses and monetary
investments such as money market funds.
You want to see a company re-invest capital in
its business by at least the rate
of depreciation expenses each year. If it
doesn't re-invest, it might show artificially
high cash inflows in the current year which
may not be sustainable.
Cash Flow From Financing Activities
This section describes the goings-on of cash
associated with outside financing activities.
Typical sources of cash inflow would be cash
raised by selling stock and bonds or by bank
borrowings. Likewise, paying back a bank loan
would show up as a use of cash flow, as
would dividend payments and common stock
repurchases.
Cash Flow Statement Considerations:
Savvy investors are attracted to companies
that produce plenty of free cash flow (FCF).
Free cash flow signals a company's ability to
pay debt, pay dividends, buy back stock and
facilitate the growth of business. Free cash
flow, which is essentially the excess cash
produced by the company, can be returned to
shareholders or invested in new growth
opportunities without hurting the existing
operations. The most common method of
calculating free cash flow is:
Ideally, investors would like to see that the
company can pay for the investing figure out
of operations without having to rely on
outside financing to do so. A company's ability
to pay for its own operations and growth
signals to investors that it has very strong
fundamentals.
While the concept behind discounted cash
flow analysis is simple, its practical application
can be a different matter. The premise of the
discounted cash flow method is that the
current value of a company is simply the
present value of its future cash flows that are
attributable to shareholders. Its calculation is
as follows:
For simplicity's sake, if we know that a company
will generate $1 per share in cash flow for
shareholders every year into the future; we can
calculate what this type of cash flow is worth
today. This value is then compared to the current
value of the company to determine whether
the company is a good investment, based on
it being undervalued or overvalued.
There are several different techniques within
the discounted cash flow realm of valuation,
essentially differing on what type of cash flow
is used in the analysis.
I)The dividend discount model focuses on the
dividends the company pays to shareholders,
while II)the cash flow model looks at the cash
that can be paid to shareholders after all
expenses, reinvestments and debt
repayments have been made. But
conceptually they are the same, as it is the
present value of these streams that are taken
into consideration.
As we mentioned before, the difficulty lies in
the implementation of the model as there are
a considerable amount of estimates and
assumptions that go into the model. As you
can imagine, forecasting the revenue and
expenses for a firm five or 10 years into the
future can be considerably difficult.
Nevertheless, DCF is a valuable tool used by
both analysts and everyday investors to
estimate a company's value.
Ratio Valuation
Financial ratios are mathematical calculations
using figures mainly from the financial
statements, and they are used to gain an idea
of a company's valuation and financial
performance. Some of the most well-known
valuation ratios are price-to-
earnings and price-to-book. Each valuation
ratio uses different measures in its calculations.
For example, price-to-book compares the price
per share to the company's book value.
The calculations produced by the valuation ratios
are used to gain some understanding of the
company's value. The ratios are compared on
an absolute basis, in which there are
threshold values. For example, in price-to-
book, companies trading below '1' are
considered undervalued. Valuation ratios are
also compared to the historical values of the
ratio for the company, along with
comparisons to competitors and the overall
market itself.
One of the most important areas for any
investor to look at when researching a
company is the financial statements. It is
essential to understand the purpose of each part
of these statements and how to interpret them.
For a company, the top line is revenue
while the bottom line is net income.
The income statement takes into account
some non-cash items, such as
depreciation.
The cash flow statement strips away all
non-cash items and tells you how
much actual money the company
generated.
The cash flow statement is divided into
three parts: cash from
operations, financing and investing.

Always read the notes to the financial

Let's recap what we've learned:
statements. They provide more in-
depth information on a wide range of
Financial reports are required by law and
figures reported in the three financial
are published both quarterly and annually.
statements.
Management discussion and

Valuation
analysis (MD&A) gives investors a better
understanding of what the company
does and usually points out some key
areas where it performed well.
What is a 'Valuation'
Audited financial reports have much Valuation is the process of determining the
more credibility than unaudited ones. current worth of an asset or a company; there
are many techniques used to determine value.
The balance sheet lists the assets,
An analyst placing a value on a company looks at
liabilities and shareholders' equity.
:
For all balance
-the company's management,
sheets: Assets = Liabilities + Shareholder
s' Equity. The two sides must always
- the composition of its capital structure,
equal each other (or balance each other).
-the prospect of future earnings
The income statement includes figures
such
- market value of assets.
as revenue, expenses, earnings and earni
ngs per share.
BREAKING DOWN 'Valuation'
The market value of a security is determined
by what a buyer is willing to pay a seller,
assuming both parties enter the transaction
willingly. When a security trades on an
exchange, buyers and sellers determine the
market value of a stock or bond.
The concept of intrinsic value, however, refers
to the perceived value of a security based on
future earnings or some other company
attribute unrelated to the market price of a
security.
How Earnings Impact Valuation
The earnings per share (EPS) formula is stated
as earnings available to common
shareholders divided by number of common
stock shares outstanding. EPS is an indicator of
company profit because the more earnings a
company can generate per share, the more
valuable each share is to investors
options strike price. If the current market
value is $65 per share, the intrinsic value is $65
- $50, or $15 per share.
Examples of Discounted Cash
Flows
Analysts also place a value on an asset or
investment using the cash inflows and
outflows generated by the asset. These cash
flows are discounted into a current value using
a discount rate, which is an assumption about
interest rates or a minimum rate of
return assumed by the investor. If a company
is buying a piece of machinery, the firm analyzes
the cash outflow for the purchase and the
additional cash inflows generated by the new
asset. All of the cash flows are discounted to
a present value, and the business determines
the net present value (NPV). If the NPV is a
positive number, the company should make the
investment and buy the asset.

. The P/E ratio calculates how expensive a

stock price is relative to the earnings
Large-Value
Stock
produced per share. For example, if the P/E
ratio of a stock is 20 times earnings, an analyst
compares that P/E ratio to other companies in the
same industry and to the ratio for the broader
A type of large-cap stock investment where
market.
the intrinsic value of the company's stock is
greater than the stock's market value. The
Factoring in Stock Options stock's intrinsic value can be determined by
Intrinsic value is also used to assess stock using a valuation model such as discounted
options. Assume an investor buys a $50, or cash flow and multiples.
strike(pactado) price, call option on XYZ common
stock. The investor has the right to exercise the BREAKING DOWN 'Large-Value
option and buy 100 shares of XYZ stock at $50
Stock'
per share before the option expiration date.
A stock's market value can fall below its
Intrinsic value is the difference between the
intrinsic value for a number of reasons.
current market price of the stock and the

For example, if a company seeks Chapter
11 bankruptcy protection, many shareholders
could become concerned that the company will
go bankrupt, and therefore sell their stock. If the
company has enough assets to pay all of
its liabilities, then there will be intrinsic value
left in the company's stock. This value may be
greater than the stock's market value, which
results in a large-value-stock investing
opportunity.
Relative Value
Relative value is a method of determining an
asset's value that takes into account the value
of similar assets. In contrast, absolute
value looks only at an asset's intrinsic
value and does not compare it to other
assets. Calculations that are used to measure
the relative value of stocks include the
enterprise ratio and price-to-earnings ratio.
BREAKING DOWN 'Relative
Value'
When value investors are considering which
stocks to invest in, they do not just look at
the financial statements of the companies whose
stocks they are interested in buying to make
sure that the company is profitable and well-
managed and that the stock is underpriced.
They also look at the financial statements of
competing companies to assess the stock's value
relative to its peers.
Fair Value
Fair value is defined as a sale price
agreed to by a willing buyer and seller,
assuming both parties enter the
transaction freely. Many investments have
a fair value determined by a market
where the security is traded. Fair value
also represents the value of a companys
assets and liabilities when a subsidiary
companys financial statements are
consolidated with a parent company.
BREAKING DOWN 'Fair Value'
The most reliable way to determine an
investments fair value is to list the
security on an exchange. If XYZ stock
trades on an exchange, market makers
provide a bid and ask price for XYZ
stock. An investor can sell the stock at
the bid price to the market maker and
buy the stock from the marker maker at
the ask price. Since investor demand for
the stock largely determines bid and ask
prices, the exchange is the most reliable
method to determine a stocks fair value.
How a Consolidation Works
Fair value is also used in a consolidation,
which is a set of financial statements
that presents a parent company and a
subsidiary firm as if the two businesses
are one company. This accounting
treatment is unusual because original cost
is used to value assets in most cases.
und the subsidiarys assets and
liabilities are presented at fair market
value for each account. When the
accounting records of both companies are
consolidated, the subsidiary companys
fair market values are used to generate
the combined set of financial statements.
Factoring in a Valuation
In some cases, it may be difficult to
determine a fair value for an asset if
there is not an active market for trading
the asset. This is often an issue when
accountants perform a company valuation.
Say, for example, an accountant cannot
determine a fair value for an unusual
piece of equipment. The accountant may
use the discounted cash flows
generated by the asset to determine a
fair value. In this case, the accountant
uses the cash outflow to purchase the
equipment and the cash inflows
generated by using the equipment over
its useful life. The value of the discounted
cash flows is the fair value of the asset.
The fair value of a derivative is determined,
in part, by the value of an underlying asset.
If you buy a 50 call option on XYZ stock,
you are buying the right to purchase 100
shares of XYZ stock at $50 per share for a
specific period of time. If XYZ stocks
market price increases, the value of the
option on the stock also increases.
Futures Market
In the futures market, fair value is the
equilibrium price for a futures contract.
This is equal to the spot price after taking
into account compounded interest (and
dividends lost because the investor owns
the futures contract rather than the physical
stocks) over a certain period of time.
Asset Value Per
Share
An asset value per share is the total value of a
fund's investments divided by its number of
shares outstanding. This type of asset value
per share is more commonly referred to as "net
asset value per share" or simply "net asset
value" or "NAV." Asset value per share can
also refer to a public company's total assets
minus its total liabilities, divided by its
number of shares outstanding. In this case,
asset value per share may be referred to as "net
current asset value per share."
BREAKING DOWN 'Asset Value
Per Share'
For most funds, asset value per share is the
price at which shares in that fund can be
bought and sold. For publicly traded
companies, investors can use asset value per
share to compare the price of the company's
stock to the underlying value of the
company's stock. Significant differences
between these two numbers can indicate a
prudent time to buy or sell.
Absolute Value
An absolute value is a business
valuation method that uses discounted cash
flow analysis to determine a company's
financial worth. The absolute value method
differs from the relative value models that
examine what a company is worth compared
to its competitors. Absolute value models try to
determine a company's intrinsic worth based
on its projected cash flows.
BREAKING DOWN 'Absolute Value'
In addition to looking at ratios such as price to
earnings and price to book value, value
investors like to calculate what an entire
business is worth when they are considering
whether to buy a particular stock. Discounted
cash flow models are one way to determine
this worth. They estimate a company's
future free cash flows, then discount that value to
the present to determine an absolute value for
the company. By comparing what a company's
share price should be given its absolute value
to the price the stock is actually trading it,
investors can determine if a stock is currently
under or overvalued.
Comparable Company
Analysis CCA
A comparable company analysis (CCA) is a
process used to evaluate the value of a
company using the metrics of other
businesses of similar size in the same
industry.
-Comparable company analysis (CCA) operates
under the assumption that similar companies
will have similar valuation multiples, such as
EV/EBITDA. Analysts compile a list of available
statistics for the companies being reviewed and
calculate the valuation multiples in order to
compare them.
BREAKING DOWN 'Comparable
Company Analysis - CCA'
I)how to do a comp analysis, or comparable
company analysis. The process of creating a
comparable company analysis is fairly
straightforward. The information the report
provides is used to determine a ballpark estimate
of value for the stock price or the firm's value.
Comparable Company Analysis
I)Comparable company analysis starts with
establishing a peer group consisting of
similar companies of similar size in the same
industry and region.
II)Investors are then able to compare a
particular company to its competitors on a
relative basis. This information can be used to
determine a company's enterprise value and
to calculate other ratios used to compare a
company to those in its peer group.
Relative vs. Comparable
Company Analysis
I)There are many ways to value a company.
The most common approaches are based on
cash flows and relative performance
compared to peers.
II)Models that are based on cash, such as the
discounted cash flow model, can help analysts
calculate an intrinsic value based on future Technical Vs. Fundamental
cash flows. This value is then compared
against the actual market value. If the intrinsic Investing - Friends Or Foes?
value is higher than the market value, the
. Yet even experienced investors debate which
stock is overvalued. If the intrinsic value is
type of analysis - fundamental or technical -
lower than the market value, the stock is
provides higher returns. Do they result in the
undervalued.
same picks? What does it mean when the two
In addition to intrinsic valuation, analysts like to approaches contradict?
confirm cash flow valuation with relative
The Difference Between Fundamental and
comparisons, and these relative comparisons
Technical Analysis
allow the analyst to develop an industry
benchmark or average. The most common
In a nutshell, fundamental analysis aims to
valuation measures used in comparable
determine intrinsic value by looking at the
company analysis are EV/revenuesor sales ue
strength of the business, a financial analysis
to sales (EV/S), price to earnings (P/E), price to
and the operating environment including
book (P/B), and price to sales (P/S). If the
macroeconomic events. Technical
company's valuation ratio is higher than the
analysis analyzes past market performance by
peer average, the company is overvalued. If
looking at the chart activity of price
the company is lower than the peer average,
movements, volume, moving averages and
the company is undervalued. Used together,
the statistics of various outcomes.
intrinsic and relative valuation models provide a
Fundamental analysis assumes the efficient
ballpark measure of valuation that can be
market theory holds in the long run and
used to help analysts gauge the true value of
attempts to take advantage of inefficiencies in
a company.
the short run.

Valuation and Transaction Technical analysis assumes fundamentals are

already priced in and tries to find patterns
Metrics Used In Comps
that lead to outcomes with high probabilities
Comps can also be based on transaction
of occurring. Technical analysis also captures
multiples. Transactions are recent
the psychological aspects of the market in the
acquisitions in the same industry. Analysts
review of past patterns, whereas fundamental
compare multiples based on the purchase
analysis fails to factor in investor psychology
price of the company rather than the stock.
but believes fundamentals will rule in the long
term, so short-term psychological blips will
If all companies in a particular industry are
correct themselves. In general, there are
selling for an average of 1.5 times market
differences in the types of investors that
value, or 10 times earnings, it gives the analyst
gravitate toward a specific type of analysis.
a way to use the same number to back into the
Technicians are usually more short-term
value of a peer company based on these
benchmarks.
traders by nature, contrasting with the long-
term view fundamentalists generally take.
Relationship Between Technicals and
Fundamentals
Do fundamentals drive technicals or the other
way around? In the short run, strong
fundamentals do not always indicate strong
technical patterns or vice versa. Often,
technicals can continue to follow a strong or
weak pattern when fundamentals are at
turning points, which may lead them to be out
of sync.
Additionally, technicals can be out of sync with
fundamentals when there is a shock to a
stock, either positive or negative. Stocks tend to
follow technicals in the short run unless there
is an unforeseen shock. For example, there are
times when stocks start moving before a new,
material disclosure becomes public. Absent
insider trading or improper disclosures by not
following Regulation D, technical analysts say
you can respond real time to a stock and not
have to wait for the next reporting date or
news disclosure, because the charts already
interpret market sentiment, so following the
charts will lead to higher profits. Technical
analysts believe that stocks move even without
disclosures because suppliers, competitors
and employees, and all their family and
friends, invest in companies and without
needing inside information, get a sense of how
the company is faring. These buying and selling
activities define the stock chart and pattern,
and reflect the real-time stock behavior.
At times when the market is surprised by a new
disclosure the charts may fail, at least initially,
and reviewing the fundamentals may lead to
long-run profits by taking advantage of short-
term mispricing when a surprise causes the
markets to overreact. News is temporary and
may positively or negatively impact the
stocks fundamentals, so following the
fundamentals after a shock may be more
prudent. Then using technical analysis may
provide the opportunity to take advantage of
a correction or rebound after the news is
absorbed.
Therefore, even if the two have been out of
sync in the short run, technicals and
fundamentals should be in sync in the long
run. That's because in the long run,
fundamentals should win and drive the
technicals.
Time Horizon
Investment time horizon often dictates when
technical or fundamental analysis makes
sense. Since at points of inflection it appears
that technicals and fundamentals are often
out of sync, investment time horizon often
comes into play. It is generally believed that
short-term investors follow technicals while
long-term investors are willing to withstand
the day-to-day blips and follow
fundamentals. For example, if you believe that
genetically modified seeds will be the seed of the
future for farmers, than you will probably invest in
a relevant company, Monsanto (NYSE:MON) for
example, and are willing to stay the course
despite any short-term noise the stock may
experience.
Curtailing Shortcomings
Critics argue that fundamental analysis can
lead to improper valuations and thus improper
investment decisions, because the
information is for the most part backward-
looking. Financial statement
analysis, 10Q and 10K commentaries and
macroeconomic environments focus on what
already happened.
Investors use this information to model expected
future results. The problem is that forecasting
is very subjective, relies on the company
management teams expectations and
disclosures, and can be in some ways a self-
fulfilling prophecy. "Garbage in, garbage out"
is a term often used in conjunction with the
modeling associated with fundamental analysis'
intrinsic value determination.
On the other hand, critics of technical analysis
think that chart patterns work until they fail, and
the failure of the pattern may not always be
predictable from following the past pattern,
especially if there is an unforeseen shock. One
way to curtail the shortcomings of the two
methods is to use them together to capture
the best aspects of both. Fundamental
analysis should be used to determine which
stocks or sectors are most likely to perform
well based on a strong macroeconomic
environment and company or sector-specific
operations. Technical analysis can then be
used to decide when to buy or sell by giving
entry and exit points based on moving
averages, volume and price trends. By
employing both strategies together, positions
can be taken in fundamentally strong
companies while avoiding buying into stocks
that have already run up and are overvalued.
Technical analysis can help you avoid buying
high or selling low, a phenomenon which
often occurs when psychology starts to rule
trading.
Fundamental and technical analysis do not
have to be contrary or held within bounds. At
times there may be a single indicator that
provides information for both the technician
and fundamentalist. For example, price
volatility is an important technical indicator of
risk - the greater the volatility, the greater the
risk. This may be a leading indicator that the
fundamentals are changing. As a result, both
would agree on the buy/sell decision.
The Bottom Line
Sometimes investors like to pigeon-hole
themselves into one type of investment style,
but being open to combining styles may
provide the best opportunity to make the
most profit. Technical and fundamental analyses
do not have to be used alone, but can be used
together to draw a complete investment
picture. Fundamentals may be used to identify
appropriate targets, while technicals can be
used to make the trading decisions. Together,
these methods can generate a confluence of
information that should provide a better
investment opportunity than either used alone.
A company's financial statements - balance
sheet, income and cash flow statements - are a
key source of data for analyzing the investment
value of its stock. Stock investors, both the do-it-
yourselfers and those who follow the guidance
of an investment professional, don't need to
be analytical experts to perform a financial
statement analysis. However, if you're going to
become a serious stock investor, a basic
understanding of the fundamentals of
financial statement usage is a must. In this
article, we help you to become more familiar with
the overall structure of the balance sheet.
Breaking Down The Balance Sheet
The Structure of a Balance Sheet
A company's balance sheet is comprised
of assets, liabilities and equity. Assets represent
things of value that a company owns and has
in its possession, or something that will be
received and can be measured objectively.
Liabilities are what a company owes to others
- creditors, suppliers, tax authorities,
employees, etc. They are obligations that
must be paid under certain conditions and
time frames. A company's equity
represents retained earnings and funds
contributed by its shareholders, who accept
the uncertainty that comes with ownership risk
in exchange for what they hope will be a
good return on their investment.
The relationship of these items is expressed in
the fundamental balance sheet equation:
Assets = Liabilities + Equity
The meaning of this equation is important.
Generally, sales growth, whether rapid or
slow, dictates a larger asset base - higher
levels of inventory, receivables and fixed
assets (plant, property and equipment). As a
company's assets grow, its liabilities and/or
equity also tends to grow in order for its
financial position to stay in balance.
How assets are supported, or financed, by a
corresponding growth in payables, debt
liabilities and equity reveals a lot about a
company's financial health. For now, suffice it to
say that depending on a company's line of
business and industry characteristics,
possessing a reasonable mix of liabilities and
equity is a sign of a financially healthy
company. While it may be an overly simplistic
view of the fundamental accounting equation,
investors should view a much bigger equity
value compared to liabilities as a measure of
positive investment quality, because
possessing high levels of debt can increase
the likelihood that a business will face
financial troubles.
Balance Sheet Formats
Standard accounting conventions present the
balance sheet in one of two formats: the
account form (horizontal presentation) and the
report form (vertical presentation). Most
companies favor the vertical report form, which
doesn't conform to the typical explanation in
investment literature of the balance sheet as
having "two sides" that balance out.
Whether the format is up-down or side-by-
side, all balance sheets conform to a
presentation that positions the various account
entries into five sections:
Assets = Liabilities + Equity
Current assets (short-term): items that are
convertible into cash within one year
Non-current assets (long-term): items of a
more permanent nature
As total assets these =
Current liabilities (short-term): oligations
due within one year
Non-current liabilities (long-term):
obligations due beyond one year
These total liabilities +
Shareholders\' equity (permanent):
shareholders\' investment and retained
earnings
Account Presentation
In the asset sections mentioned above, the
accounts are listed in the descending order of
their liquidity (how quickly and easily they
can be converted to cash). Similarly, liabilities
are listed in the order of their priority for
payment. In financial reporting, the
terms"current"and "non-current" are synonymous
with the terms "short-term" and "long-term,"
respectively, and are used interchangeably.
It should not be surprising that the diversity of
activities included among publicly-traded
companies is reflected in balance sheet
account presentations. The balance sheets of
utilities, banks, insurance companies,
brokerage and investment banking firms and
other specialized businesses are significantly
different in account presentation from those
generally discussed in investment literature. In
these instances, the investor will have to
make allowances and/or defer to the experts.
The Importance of Dates
A balance sheet represents a company's financial
position for one day at its fiscal year end, for
example, the last day of its accounting period,
which can differ from our more familiar calendar
year. Companies typically select an ending
period that corresponds to a time when
their business activities have reached the
lowest point in their annual cycle, which is
referred to as their natural business year.
In contrast, the income and cash
flow statements reflect a company's
operations for its whole fiscal year - 365 days.
Given this difference in "time," when using data
from the balance sheet (akin to a photographic
snapshot) and the income/cash flow statements
(akin to a movie) it is more accurate, and is the
practice of analysts, to use an average number
for the balance sheet amount. This practice is
referred to as "averaging," and involves
taking the year-end (2004 and 2005) figures -
let's say for total assets - and adding them
together, and dividing the total by two. This
exercise gives us a rough but useful
approximation of a balance sheet amount for
the whole year 2005, which is what the
income statement number, let's say net
income, represents. In our example, the number
for total assets at year-end 2005 would
overstate the amount and distort the return
on assets ratio (net income/total assets).
A Simplified Approach to Cash Flow Analysis
A company's cash flow can be defined as the
number that appears in the cash flow
statement as net cash provided by operating
activities, or "net operating cash flow," or
some version of this caption. However, there is
no universally-accepted definition. For instance,
many financial professionals consider a
company's cash flow to be the sum of its net
income and depreciation (a non-cash
charge in the income statement). While often
coming close to net operating cash flow, this
professional's shortcut can be way off the
mark and investors should stick with the net
operating cash flow number.
the following indicators provide a starting point for
an investor to measure the investment quality of
a company's cash flow:
Operating Cash Flow/Net Sales
This ratio, which is expressed as a percentage of
a company's net operating cash flow to its net
sales, or revenue (from the income statement),
tells us how many dollars of cash we get for
every dollar of sales.
There is no exact percentage to look for but
obviously, the higher the percentage the better.
It should also be noted that industry and
company ratios will vary widely. Investors
should track this indicator's performance
historically to detect significant variances
from the company's average cash flow/sales
relationship along with how the company's
ratio compares to its peers. Also, keep an eye
on how cash flow increases as sales
increase; it is important that they move at a
similar rate over time.
History of Free Cash Flow
Free cash flow is often defined as net
operating cash flow minus capital
expenditures, which, as mentioned previously,
are considered obligatory. A steady, consistent
generation of free cash flow is a highly favorable
investment quality so make sure to look for a
company that shows steady and growing free
cash flow numbers.
For the sake of conservatism, you can go one
step further by expanding what is included in
the free cash flow number. For example, in
addition to capital expenditures, you could also
include dividends for the amount to be
subtracted from net operating cash flow to
get to get a more comprehensive sense of
free cash flow. This could then be compared to
sales, as was shown above.
As a practical matter, if a company has a
history of dividend payments, it cannot easily
suspend or eliminate them without causing
shareholders some real pain. Even
dividend payout reductions, while less
injurious, are problematic for many
shareholders. In general, the market considers
dividend payments to be in the same
category as capital expenditures as
necessary cash outlays.
But the important thing here is looking for
stable levels. This shows not only the
company's ability to generate cash flow but it
also signals that the company should be able
to continue funding its operations.
Comprehensive Free Cash Flow Coverage
You can calculate a comprehensive free cash
flow ratio by dividing the comprehensive free
cash flow / net operating cash flow to get a
percentage ratio the higher the percentage
the better.
Free cash flow is an important evaluative
indicator for investors. It captures all the
positive qualities of internally produced cash
from a company's operations and subjects it
to a critical use of cash capital expenditures.
If a company's cash generation passes this test
in a positive way, it is in a strong position to
avoid excessive borrowing, expand its
business, pay dividends and to weather hard
times.
The term "cash cow," which is applied to
companies with ample free cash flow, is not a
very elegant term, but it is certainly one of the
more appealing investment qualities you can
apply to a company with this characteristic.
Bond Valuation
What is 'Bond Valuation'
Bond valuation is a technique for determining
the fair value of a particular
bond. Bond valuation includes calculating
the present value of the bond's future interest
payments, also known as its cash flow, and
the bond's value upon maturity=face
value or par value. Because a bond's par
value and interest payments are fixed, an
investor uses bond valuation to determine
what rate of return is required for an
investment in a particular bond to be
worthwhile.
BREAKING DOWN 'Bond
Valuation'
Bond valuation is only one of the factors
investors consider in determining whether to
invest in a particular bond.
Other important considerations are: the issuing
company's creditworthiness, which
determines whether a bond is investment-
grade or junk; the bond's price appreciation
potential, as determined by the issuing
company's growth prospects; and prevailing
market interest rates and whether they are
projected to go up or down in the future.
Discount Bond
A bond that is issued for less than its par (or
face) value, or a bond currently trading for less
than its par value in the secondary market. A
bond is considered a discount bond when it
has a lower interest rate than the current
market rate, and consequently is sold at a
lower price. This interest rate, also called
a coupon, is usually paid semiannually. As
interest rates go up, bond prices go down.
Discount bonds are similar to zero-coupon
bonds, which are also sold at a discount, but the
difference is that they don't pay interest. Common
examples of discount bonds are U.S. Treasury
bills and U.S. savings bonds.
A deep-discount bond is sold at a significantly
lower price than par value, usually 20% or
more.
BREAKING DOWN 'Discount Bond'
Discount bonds can be bought and sold by
both businesses and individuals. Businesses
have strict regulations for the selling and
purchasing of discount bonds; they must keep
detailed expense records of the discount bonds
bought and sold on a balance sheet.
The "discount" in a discount bond doesn't
necessarily mean that investors get a
better yield than the market is offering, just a
price below par. Depending on the length of
time until maturity, zero-coupon bonds can be
issued at very large discounts to par,
sometimes 50% or more. A coupon, in the
context of bonds, refers to
the interest payments made. The frequency at
which these coupons must be paid doesn't
change; however, the amount of interest
does, depending on market factors. Selling a
bond before it's mature can result in either a
gain or a loss.
Often, a bond purchased in the past is either
discounted or sold as a premium bond when
it enters the current market, in order to balance
it out with other bonds that are being sold. A
discount bond is the opposite of a premium
bond, which occurs when the market price of
a bond is higher than the price for which it
was originally sold. To compare the two in the
current market, and to convert older bond
prices to their value in the current market,
you can use a calculation called yield to
maturity. Yield to maturity considers the
bond's current market price, par value,
coupon interest rate, and time to maturity in
order to calculate a bond's return.
Examples of Discount Bonds
Let's say you bought a bond a few years ago,
but now you want to sell it. The value of your
bond will most likely be different, since the
market is constantly fluctuating. Let's say that
interest rates have risen from 5% when you
originally purchased the bond, to 10%. A
potential investor will insist that you match
this new 10% interest rate before purchasing
the bond at face value. Alternatively, you could
sell your bond for a lower price originally, so that
the difference matches the amount of projected
interest, and not have to worry about making
interest payments at all. The amount of this
projected interest will match the amount of
your annual coupon, totaled over all years of
payment. For example, if your coupon is for $20
and your bond has five years until maturity,
the total interest will be $100, and an investor
can pay that much less for the bond initially,
rather than receiving coupons. Either way, in
this situation, you hold a discount bond, since
interest rates have gone up and consequently,
the price is below the current market value.
Let's take another example, to show a bit of
what a business needs to do when selling a
discount bond. In this situation, the bond seller
is a business that originally purchased the
bond for $10,000 but is now selling it at $9,000
due to rising interest rates. On the balance
sheet, the business would need to record the
current value of the bond, $9,000, and the
amount of the discount, $1,000, to calculate the
"Bond Payable" field, $10,000. The business
would also need to amortize the amount, or
pay it off in fixed installments over a set time
frame. Amortization works much
like depreciation, in that it reduces the discount
amount over time, so that when the bond
matures, the bond's carrying amount matches its
face value. At this point, the business pays off the
face value.
Pros and Cons of Purchasing a
Discount Bond
If you buy a discount bond, the chances of
seeing the bond appreciate in value are fairly
high, as long as the lender doesn't default. If
you hold out until the bond is mature, you'll be
paid the face value of the bond, even though
what you originally paid was less than face
value. Maturity rates vary between short-term
and long-term; short-term bonds are usually
called bills, and they mature in less than a
year, while long-term bonds mature over ten to
fifteen years, or even longer.
However, the chances of default might be
higher, as a discount bond can indicate that
the lender is in a less than ideal place in the
market or will likely be in the future. This article
specifically discusses both the causes and
effects of discount bonds, comparing 2015
rates with those from the 2008 financial crisis
and showing the relationship between
interest rates and discount bonds. The
presence of discount bonds can indicate many
things, such as predictions of falling
dividends or a reluctance to buy on the part of
the investors.
Because a bond will always pay its full face
value at maturity (assuming no credit events
occur), discount bonds issued below par
such as zero-coupon bonds will steadily
rise in price as the maturity date approaches.
These bonds will only make one payment to the
holder (par value at maturity) as opposed to
periodic interest payments.
A distressed bond (one that has a high
likelihood of default) can also trade for huge
discounts to par, effectively raising its yield to
very attractive levels. The consensus, however,
is that these bonds will not receive full or
timely interest payments at all; because of this,
investors who buy into these issues become
very speculative, possibly even making a play
for the company's assets or equity.
Dollar Price
The percentage of par, or face value, at which
a bond is quoted. Dollar price is one method
by which the price of a bond is quoted. Bonds
are used by companies, municipalities, states,
and U.S. and foreign governments to finance a
variety of projects and activities. For example, a
municipal government may issue bonds to fund
the construction of a school. A corporation, on
the other hand, might issue a bond to expand
its business into a new territory.
BREAKING DOWN 'Dollar Price'
The price of a bond can be quoted in one of
two ways by the various exchanges: by dollar
price and by yield. Frequently, providers of
bond quotes publish both the dollar price and
yield concurrently. A bond's yield indicates
the annual return until the bond matures. For
example, if an investor purchases a bond with a
10% coupon at its $1,000 par value, the yield is
10% ($100/$1,000). The dollar price, on the
other hand, represents a percentage of the
bond's principal balance, also called its par
value. A bond is a loan (made to a corporate or
government entity) and the par value is the
loan amount.
For example, if the price of a bond is $1,120 and
the par value of the bond is $1,000, the bond
would be quoted at 112% in dollar terms. A bond
that is selling at par (at its face value) would be
quoted at 100 in terms of dollar price. A bond that
is trading at a premium will have a price greater
than 100; a bond that is traded at a discount will
have a price that is less than 100.
the price of the bond and its yield are inversely
related.
Bond Discount
The amount by which the market price of
a bond is lower than its principal amount due at
maturity. This amount, called its par value, is
often $1,000. As bond prices are quoted as a
percent of face value, a price of 98.00 means
that the bond is selling for 98% of its face
value of $1,000.00 and the bond discount is
2%.
BREAKING DOWN 'Bond
Discount'
Bonds trade at a discount to par value for a
number of reasons.
I)Bonds on the secondary market with fixed
coupons will trade at discounts when market
interest rates rise. While the investor receives
the same coupon, the bond is discounted to
match prevailing market yields.
II)Discounts also occur when bond supply
exceeds demand,
III)when the bond's credit rating is lowered, or
when the perceived risk of default increases.
Conversely, falling interest rates or an
improved credit rating may cause a bond to
trade at a premium.
Bond Yield
A bond yield is the amount of return an
investor realizes on a bond. Several types of
bond yields exist, including nominal
yield which is the interest paid divided by
the face value of the bond, and current
yield which equals annual earnings of the
bond divided by its current market price.
Additionally, required yield refers to the
amount of yield a bond issuer must offer to
attract investors.
BREAKING DOWN 'Bond Yield'
The money that investors earn is called yield.
Investors do not have to hold bonds to
maturity. Instead, they may sell them for a higher
or lower price to other investors, and if an
investor makes money on the sale of a bond,
that is also part of its yield.
Bond Yield Versus Price
As bond prices increase, bond yields fall. For
example, assume an investor purchases a bond
with a 10% annual coupon rate and a par
value of $1,000. Each year, the bond pays 10%,
or $100, in interest. Its annual yield is the
interest divided by its par value. As $100
divided by $1,000 is 10%, the bond's nominal
yield is 10%, the same as its coupon rate.
Eventually, the investor decides to sell the
bond for $900. The new owner of the bond
receives interest based on the face value of the
bond, so he continues to receive $100 per year
until the bond matures. However, because he
only paid $900 for the bond, his rate of return
is $100/$900 or 11.1%. If he sells the bond for a
lower price, its yield increases again.
However, if he sells for a higher price, its yield
falls.
When Do Bond Yields Fall?
Generally, investors see bond yields fall
when economic conditions push markets
toward safer investments. Economic
conditions that might decrease bond yields
include high rates of unemployment and
slow economic growth or recession. As
interest rates increase, bond prices also tend
to fall.
Interest Rates Versus Bond
Prices
To examine the relationship between interest
rates and bond prices, imagine an investor buys
a bond from ABC Corporation with a 4% coupon
rate and a $1,000 face value. Another investor BREAKING DOWN 'Par Value'
waits a few weeks before buying a bond, and
One of the main factors that causes bonds to
during that time, the issuer raises interest rates
trade above or below par value is the level of
to 6%. At this point, the second investor can
interest rates in the economy, as compared to
buy a $1,000 bond from ABC Corporation and
the bonds coupon rates.
receive $60 in interest per year.
A bond with a 4% coupon will trade below par
Meanwhile, upset that he is only earning $40 per
if interest rates are at 5%. This is because in
year, the original investor decides to sell, but
such a scenario, investors have a choice of
to entice others to buy his bond instead of
buying similar-rated bonds that have a 5%
bonds directly from ABC Corporation, he
coupon. The price of a lower-coupon bond
lowers his price. For example, he lowers it to
therefore must decline to offer the same 5%
$650, making its effective annual
yield to investors. (nominal rate).Likewise, a
yield $40/$650 or 6.15%. If the bond issuer had
bond with a 4% coupon will trade above par if
not increased its rates, the investor might not
interest rates are at 3%.
have had to sell his bond for less than its face
value. A bond that is trading above par is said to be
trading at a premium, while a bond trading

Par Value below par is regarded as trading at a

The face value of a bond. Par value for a share
refers to the stock value stated in the corporate
charter. Par value is important for a bond
or fixed-income instrument because it
determines its maturity value as well as the
discount. During periods when interest rates are
low or have been trending lower, a larger
proportion of bonds will trade above par or at
a premium. When interest rates are high, a
larger proportion of bonds will trade at a
discount.

Effective
dollar value of coupon payments. Par value for
a bond is typically $1,000 or $100. Shares
usually have no par value or very low par

Interest Method
value, such as 1 cent per share. The market
price of a bond may be above or below par,
depending on factors such as the level of
interest rates and the bonds credit status. In
The effective interest rate is a method used by
the case of equity, par value has very little
a bond buyer to account for accretion of a
relation to the shares' market price.
bond discount as the balance is moved into
interest income, and to amortize a bond
Also known as nominal value or face value.
premium into an interest expense. The
effective interest rate uses the book value, or
the carrying amount of the bond, to calculate
interest income, and the difference between carrying amount so the new carrying amount of
interest income and the bonds interest $384,817 is used to calculate bond accretion for
payment is the amount of the accretion or year two. At the end of the 10-year life of the
amortization posted each year. bond, the carrying amount is adjusted up to the
$500,000 par amount.
BREAKING DOWN 'Effective
Interest Method' Factoring in Bond Amortization
A bond purchased at a premium generates a
Bonds are normally issued at a par, or face,
larger cost of debt for the bond buyer,
value, of $1,000 and sold in multiples of $1,000.
because the premium paid is amortized into bond
If a bond is purchased at less than par, the
expense. Assume, in this case, a 4.5%, $100,000
amount below the par value is the bond
par value bond is purchased for $104,100,
discount, and since the bond returns the par
which includes a $4,100 premium. The annual
amount to the purchaser at maturity, the
interest payment for the bond is $4,500, but the
discount is additional bond income to the
interest income earned in year one is less than
buyer. In a similar way, a bond purchased at a
$4,500 because the bond was purchased at a
price above par includes a bond premium,
market rate of only 4%. The actual interest
and the premium is an additional expense to
income is 4% multiplied by the $104,100 carrying
the bond buyer because the buyer only
amount, or $4,164, and the premium amortization
receives the par amount at maturity.
for year one is $4,500 less $4,164, which equals
How Accretion Works $336. The amortization of $336 is posted to bond
expense, and the amount also reduces the
Assume an investor buys bonds with a $500,000
carrying amount of the bond.
par value and a coupon rate of 6%; the bonds are
purchased for $377,107, which includes a bond
discount from par of $122,893. The bonds
interest income is calculated as the carrying Current Yield
amount multiplied by the at the market interest
rate, which is the total return earned on the bond Current yield is an investment's annual income
given the discount paid and the interest earned. (interest or dividends) divided by the current
In this case, assume the market interest rate is price of the security. This measure looks at
10%, which is multiplied by the $377,107 carrying the current price of a bond instead of its face
amount to calculate $37,710 in interest income. value. Current yield represents the return an
investor would expect if the owner purchased
The bond pays annual interest of 6% on a
the bond and held it for a year, but current yield
$500,000 par amount, or $30,000, and the
is not the actual return an investor receives if he
difference between the interest paid and interest
holds a bond until maturity.
income, or $7,710, is the amount of the bond
discount accretion for year one. The bond
accretion for the year is moved into bond income,
and the accretion amount is also added to the
BREAKING DOWN 'Current
Yield'
Current yield is most often applied to bond
investments, which are securities that are
issued to investor at a par value (face
amount) of $1,000. A bond carries
a coupon amount of interest that is stated on
the face of the bond certificate, and bonds are
traded between investors. Since the market
price of a bond changes, an investor may
purchase a bond at a discount (less than par
value) or at a premium (more than par value),
and the purchase price of a bond affects the
current yield.
How Current Yield Is Calculated
If an investor buys a 6% coupon rate bond for a
discount of $900, the investor earns annual
interest income of ($1,000 X 6%), or $60. The
current yield is ($60) / ($900), or 6.67%. The $60
in annual interest is fixed, regardless of the price
paid for the bond. If, on the other hand, an
investor purchases a bond at a premium of
$1,100, the current yield is ($60) / ($1,100), or
5.45%. The investor paid more for the premium
bond that pays the same dollar amount of
interest, so the current yield is lower.
Current yield can also be calculated for stocks
by taking the dividends received for a stock
and dividing the amount by the stocks
current market price.
Factoring in Yield to Maturity
Yield to maturity (YTM) is the total return
earned on a bond, assuming that the bond
owner holds the bond until maturity date.
Assume, for example, that the 6% coupon rate
bond purchased for a discount of $900
matures in the 10 years. To calculate YTM, an
investor needs to make an assumption about
a discount rate, so that the future principal
and interest payments are discounted to present
value.
In this example, the investor receives $60 in
annual interest payments for 10 years. At
maturity in 10 years, the owner receives the par
value of $1,000, and the investor recognizes a
$100 capital gain. The present value of the
interest payments and the capital gain are added
to compute the bond's YTM. If the bond is
purchased at a premium, the YTM calculation
includes a capital loss when the bond matures
at par value.
Below Par
A term describing a bond whose price is below
the face value or principal value, usually $1,000.
As bond prices are quoted as a percentage of
face value, a price below par would typically
be anything less than 100.
BREAKING DOWN 'Below Par'
A bond trading below par is the same as a bond
trading at a discount. When a bond trades
below par, its current yield is higher than its
fixed coupon rate.
Bonds may trade below par when interest
rates have risen since it was issued, its credit
rating has declined, there are concerns about
a default, or there is an excess supply. A
bond's discount may narrow as it approaches
maturity or its first call date, when investors
will receive par value.
Bond Quote
A bond quote is the last price at which a bond
traded, expressed as a percentage of par value
and converted to a point scale. Par value is
generally set at 100, representing 100% of a
bond's face value of $1,000. For example, a
corporate bond quoted at 99 is trading at 99%
of face value, meaning the cost of buying each
bond is $990.
BREAKING DOWN 'Bond Quote'
Price quotes for bonds are represented by a
percentage of the bond's par value, which is
converted to a numeric value and multiplied by
10 to determine the cost per bond. Bond
quotes can also be expressed as fractions,
with corporate bonds quoted in 1/8th
increments, and government bills, notes and
bonds quoted in increments of 1/32nd. For
example, a bond quote of 99 1/4 represents
99.25% of par. Converting the percentage to
99.25 and multiplying by 10 results in a cost of
$992.5 per bond. In addition to being quoted as
a percentage of par value, bonds may also be
quoted with a yield to maturity (YTM).
Full Bond Quotes
In addition to the last price at which a trade
occurred, full bond quotes include bid and
ask prices, which are calculated in the same
manner as the quote on the last trade. The bid
is the highest price level buyers are willing to
pay for the bond at the time of the quote. For
bond sellers seeking immediate trade
executions, the bid is the likely price for the
trade. The ask is the lowest price level on
bonds to be sold at the time of the quote.
The difference between the bid and the ask
price is referred to as the spread. In a full
quote, bonds with high levels of liquidity, such
as Treasuries, generally have spreads of a
few pennies between the bid and the ask
price. The spreads on corporate bonds with
lower levels of liquidity, on the other hand,
can exceed $1. For example, a full quote on an
illiquid corporate bond could list a last trade
of $98, with a bid of $97 and an ask price of
$99.
Quotes Based on Yield
Bonds can also be quoted in terms of their
yield to maturity (YTM),
which is commonly done for reference
purposes rather than trading. For example, the
financial media often quotes the 10-year Treasury
note by its YTM, to give listeners and viewers a
reference point for fluctuations in bond prices.
For example, a YTM-based quote on the 10-year
Treasury note could be presented as 1.92%,
down from the previous close of 1.94%, an
indication of an increase in bond prices for the
day.
How Bond Market Pricing Works
. Bond market classifications are briefly
discussed, followed by yield calculations,
pricing benchmarks and pricing spreads.
A basic knowledge of these pricing conventions
will make the bond market seem as exciting as
the best World Series baseball game.

Bond Market Classifications
The bond market consists of a great number
of issuers and types of securities. e make the
following major bond classifications:
U.S. Treasuries: Bonds issued by the
United States Department of the
Treasury.
Corporate Bonds: Bonds issued by
corporations that carry an investment
grade rating.
High-Yield Bonds: Also known as non-
investment grade, or junk bonds, these
are bonds with a below investment
grade rating.
Mortgage-Backed Securities (MBS): A
bond collateralized by the cash flows
of principal and interest payments from
an underlying pool of single family
residential mortgages.
Asset-Backed Securities (ABS): A bond
collateralized by the cash flows of an
underlying pool of assets such as auto
loans, credit card receivables, home
equity loans, aircraft leases, etc. The
list of assets that has been securitized
into ABSs is almost endless.
Agency Bonds: Debt issued by
the government-sponsored
enterprises (GSEs), including Fannie
Mae, Freddie Mac and the Federal Home
Loan Banks.
Municipal Bonds (Munis): A bond issued
by a state, city or local government or
its agencies.
Collateralized Debt Obligations (CDOs): A
type of asset-backed security backed
by any one or several other ABS, MBS,
bonds or loans.
A Bond's Expected Return
Yield is the measure used most frequently to
estimate or determine a bond's expected
return.
Yield is also used as a relative value measure
between bonds. There are two primary yield
measures that must be understood to
understand how different bond market pricing
conventions work: yield to maturity and spot
rates.
A yield-to-maturity calculation is made by
determining the interest rate (discount rate)
that will make the sum of a bond's cash flows,
plus accrued interest, equal to the current
price of the bond.
This calculation has two important
assumptions: first, that the bond will be held
until maturity, and second that the bond's
cash flows can be re-invested at the yield to
maturity.
A spot rate calculation is made by determining
the interest rate (discount rate) that makes
the present value of a zero-coupon
bond equal to its price. A series of spot rates
must be calculated to price a coupon paying
bond each cash flow must be discounted
using the appropriate spot rate, such that the
sum of the present values of each cash flow
equals the price. As we discuss later, spot rates
are most often used as a building block in
relative value comparisons for certain types
of bonds.
Benchmarks three month, six month, two year, three year,
five year, 10 year and 30 year maturities, the
Most bonds are priced relative to a benchmark.
yields of theoretical bonds with maturities
This is where bond market pricing gets a little
that lay between those maturities must be
tricky. Different bond classifications, as we
interpolated. This Treasury curve is known as
have defined them above, use different
the interpolated yield curve (or I-curve) by
pricing benchmarks.
bond market participants.
Some of the most common pricing
benchmarks are on-the-run U.S. Other Popular Benchmark Pricing
Treasuries (the most current series). Many Curves
bonds are priced relative to a specific Treasury
bond. For example, the on-the-run 10-year Spot Rate Treasury Curve: A curve
Treasury might be used as the pricing constructed using the theoretical spot
benchmark for a 10-year corporate bond rates of U.S. Treasuries.
issue.
Swap Curve: A curve constructed using
When the maturity of a bond cannot be known the fixed interest rate side of interest
with exactness because of call or put rate swaps.
features, the bond is frequently priced to a
Eurodollars Curve: A curve
benchmark curve. This is because the
constructed using interest rates
estimated maturity of the callable or put-able
derived from eurodollar futures pricing.
bond most likely does not coincide exactly
with the maturity of a specific Treasury. Agency Curve: A curve constructed
using the yields of non-callable, fixed-
Benchmark pricing curves are constructed rate agency debt.
using the yields of underlying securities with
maturities from three months to 30 years. Yield Spreads
Several different benchmark interest rates or
A bond's yield relative to the yield of its
securities are used to construct different
benchmark is called a spread. The spread is
benchmark pricing curves. Because there are
used both as a pricing mechanism and as a
gaps in the maturities of securities used to
relative value comparison between bonds. For
construct a curve, yields must be interpolated
example, a trader might say that a certain
between the observable yields.
corporate bond is trading at a spread of
75 basis points above the 10-year Treasury.
For example, one of the most commonly used
This means that the yield to maturity of that
benchmarks curves is the on-the-run U.S.
bond is 0.75% greater than the yield to
Treasury curve, which is constructed using
maturity of the on-the-run 10-year Treasury. If
the most recently issued U.S. Treasury
a different corporate bond with the same credit
bonds, notes, and bills. Because securities
rating, outlook and duration was trading at a
are only issued by the U.S. Treasury with
spread of 90 basis points on a relative value
basis, the second bond would be a better buy.
There are different types of spread
calculations used for the different pricing
benchmarks. The four primary yield
spread calculations are:
Spreads are calculated metrics that often
requires that a trader manually determine the
difference between bid and ask prices. For
traders trying to capture small fluctuations in the
spread, determining the spread requires handling
quotes with a large number following the decimal.
As a result, the spread indicator fluctuates over a
very narrow range.
Yield Spread: A yield spread is the difference
between yields on differing debt instruments of
varying maturities, credit ratings and risk,
calculated by deducting the yield of one
instrument from another. For example, if the five-
year Treasury bond is at 5% and the 30-year
Treasury bond is at 6%, the yield spread between
the two debt instruments is 1%. If the 30-year
bond is trading at 6%, then based on the
historical yield spread, the five-year should be
trading at around 1%, making it very attractive at
its current yield of 5%.
Nominal Yield Spread: The difference in
the yield to maturity of a bond and the
yield to maturity of its benchmark.
ominal yield spreads are a convention
frequently used in pricing certain types of
mortgage-backed securities (MBS). These
MBSs are priced at a spread over the
interpolated Treasury curve at the point
equal to their weighted average life.
Zero-Volatility Spread (Z-spread): The
constant spread that, when added to
the yield at each point on the spot rate
Treasury curve where a bond's cash
flow is received, will make the price of
a security equal to the present value of
its cash flows.
tatic or Z-spread calculations are
frequently used in mortgage-backed
securities and other bonds with
embedded options valuation.
. In other words, each cash flow is discounted at
the appropriate Treasury spot rate + the Z-
spread. The Z-spread is also known as a static
spread.
The Z-spread helps analysts discover if there is a
discrepancy in a bond's price. Because the Z-
spread measures the spread that an investor will
receive over the entirety of the Treasury yield
curve, it gives analysts a more
realistic valuation of a security instead of a
single-point metric, such as a bond's maturity
date.
Z-Spread Calculation
A Z-spread calculation is different than
a nominal spread calculation. A nominal spread
calculation uses one point on the Treasury
yield curve (not the spot-rate Treasury yield
curve) to determine the spread at a single point
that will equal the present value of the
security's cash flows to its price.
To calculate a Z-spread, an investor must take
the Treasury spot rate at each relevant maturity,
add the Z-spread to this rate, and then use this
combined rate as the discount rate to calculate
the price of the bond. The components that go
into a Z-spread calculation are as follows:
P = the current price of the bond plus any
accrued interest
C(x) = bond coupon payment
r(x) = the spot rate at each maturity
Z = the Z-spread
T = the total cash flow received at the bond's
maturity
n = the relevant time period
The generalized formula is:
P = {C(1) / (1 + (r(1) + Z) / 2) ^ (2 x n)} + {C(2) /
(1 + (r(2) + Z) / 2) ^ (2 x n)} + {C(n) / (1 + (r(n) +
Z) / 2) ^ (2 x n)}
For example, assume a bond is currently priced
at $104.90. It has three future cash flows: a $5
payment next year, a $5 payment two years from
now and a final total payment of $105 in three
years. The Treasury spot rate at the one-, two-,
and three- year marks are 2.5%, 2.7% and 3%.
The formula would be set up as follows:
$104.90 = $5 / (1 +(2.5% + Z) / 2) ^ (2 x 1) + $5 /
(1 +(2.7% + Z) / 2) ^ (2 x 2) + $105 / (1 +(3% + Z)
/ 2) ^ (2 x 3)
With the correct Z-spread, this simplifies to:
$104.90 = $4.87 + $4.72 + $95.32
This implies that the Z-spread equals 0.5% in this
example
Option-Adjusted Spread (OAS): An OAS
is used to evaluate bonds
with embedded options (such as a
callable bond or put-able bond). It is
the constant spread that, when added
to the yield at each point on a spot rate
curve (usually the U.S. Treasury spot
rate curve) where a bond's cash flow is
received, will make the price of the
bond equal to the present value of its
cash flows. However, to calculate the
OAS, the spot rate curve is given
multiple interest rate paths. In other
words, many different spot rate curves
are calculated and the different interest
rate paths are averaged An OAS
accounts for interest rate volatility and
the probability of the prepayment of
principal of the bond.
which is frequently used to value bonds with
embedded options, is essentially a static
spread calculation based on multiple interest
rate paths and the prepayment rates
associated with each interest rate path
Discount Margin (DM): Bonds with variable
interest rates are usually priced close to
their par value. This is because the
interest rate (coupon) on a variable rate
bond adjusts to current interest rates
based on changes in the bond's reference
rate. The DM is the spread that, when
added to the bond's current reference rate,
will equate the bond's cash flows to its
current price.
Spot Rate Treasury
Curve
The spot rate treasury curve is a yield need to be further discounted to account for
curve constructed using Treasury spot rates its increased risk compared to Treasury
rather than yields. The spot rate Treasury bonds.
curve can be used as a benchmark for pricing
bonds. This type of rate curve can be built
from on-the-run treasuries, off-the-run

Yield Spread
treasuries or a combination of both.
Alternatively, the Treasury curve can be
calculated by using Treasury coupon strips.
A yield curve is a line that plots the interest
BREAKING DOWN 'Spot Rate rates, at a set point in time, of bonds having
equal credit quality but differing maturity
Treasury Curve'
dates. The most frequently reported yield
Because many bonds typically have multiple
curve compares the three-month, two-year,
cash flows (coupon payments) at different
five-year and 30-year U.S. Treasury debt. This
points in the bonds' lives, it is not
yield curve is used as a benchmark for other
theoretically correct to use just one interest
debt in the market, such as mortgage rates or
rate to discount all of the cash flow. Therefore,
bank lending rates, and it is also used to
in order to make a sound bond valuation, it is
predict changes in economic output and growth.
good practice to match up and discount each
coupon payment with the corresponding
Treasury spot rate for pricing the present
value of each price.

For example, suppose that a corporate two-

year 10% coupon bond is being priced using
Treasury spot rates. The Treasury spot rates
for the subsequent four periods (each year is
composed of two periods) are 8%, 8.05%,
8.1% and 8.12%, and the four corresponding
cash flows are $5, $5, $5, $105. The present
BREAKING DOWN 'Yield Curve'
value for each respective cash flow will be $4.81,
$4.62, $4.44 and $89.50. Therefore, the sum of The shape of the yield curve gives an idea of

all the cash flows will be $103.36.
However, $103.36 is not necessarily the price
at which the corporate bond will ultimately be
sold. Because the spot rates used to price
bonds reflect rates that are from default-free
Treasuries, the corporate bond's price will
future interest rate changes and economic
activity. There are three main types of yield
curve shapes: normal, inverted and flat (or
humped). A normal yield curve is one in which
longer maturity bonds have a higher yield
compared to shorter-term bonds due to the
risks associated with time. An inverted yield
curve is one in which the shorter-term yields
are higher than the longer-term yields, which
can be a sign of upcoming recession. In a flat
or humped yield curve, the shorter- and longer-
term yields are very close to each other,
which is also a predictor of an economic
transition.
Normal Yield Curve
A normal or up-sloped yield curve indicates
yields on longer-term bonds may continue to
rise, responding to periods of economic
expansion. When investors expect longer-
maturity bond yields to become even higher
in the future, many would temporarily park
their funds in shorter-term securities in hopes
of purchasing longer-term bonds later for
higher yields. In a rising interest rate
environment, it is risky to have investments
tied up in longer-term bonds when their value
has yet to decline as a result of higher yields
over time. The increasing temporary demand for
shorter-term securities pushes their yields even
lower, setting in motion a steeper up-sloped
normal yield curve.
Inverted Yield Curve
An inverted or down-sloped yield curve
suggests yields on longer-term bonds may
continue to fall, corresponding to periods of
economic recession. When investors expect
longer-maturity bond yields to become even
lower in the future, many would purchase
longer-maturity bonds to lock in yields before
they decrease further. The increasing onset of
demand for longer-maturity bonds and the lack
of demand for shorter-term securities lead to
higher prices but lower yields on longer-
maturity bonds, and lower prices but higher
yields on shorter-term securities, further
inverting a down-sloped yield curve.
Flat Yield Curve
A flat yield curve may arise from normal or
inverted yield curve, depending on changing
economic conditions. When the economy is
transitioning from expansion to slower
development and even recession, yields on
longer-maturity bonds tend to fall and yields on
shorter-term securities likely rise, inverting a
normal yield curve into a flat yield curve. When
the economy is transitioning from recession to
recovery and potentially expansion, yields on
longer-maturity bonds are set to rise and yields
on shorter-maturity securities are sure to fall,
tilting an inverted yield curve toward a flat yield
curve.
A par curve is the most commonly referred to
curve by media and market watchers. The Spot
curve is more often user to calculate the fair
value of a particular bond.
When people quote the par curve they give you
the yields of various maturity bonds. Each of
the referred to bonds will usually have
different yields and pay semi-annual interest
payments and a bullet or single payment
maturity. Since each par bond is a collection of
payments the yield quoted on each bond is
really the average return for several different
term investments. Said another way, a 2yr
maturity par bond will make interest payments in
months 6,12,18,24 and a maturity payment in month
24. The quoted yield for the bond is IRR for the
whole series of payments. (In essence a
weighted average return for the whole period.)
A spot curve is more pure in that each node or
maturity is quoted as a zero coupon (only one
cash flow at maturity) bond so the yield quoted
is for the period from settlement date to maturity
with no interference from intervening cash flows.
You can solve from par to spot curves or vice versa
since the par bonds have so much overlap.
For example, if we look now at a 3yr bond, it also pays
interest payments in months 6,12,18,24, and has two
more payment dates in months 30, and 36. Valuing
the 3yr bond in comparison to the 2y bond should
really only involve determining the discount rate for Treasury. For example, a 10-
the last two payments because both bonds contain the
same exposures for the first 4 payments.
year planned amortization class bond
might trade at a nominal yield spread
The spot curve is derived from the par curve. to the on-the-run 10-year Treasury, or
a Z-bond might trade at a nominal yield
Then, the forward curve is derived from the spot
curve.
spread to the on-the-run 30-year
Treasury. Because MBS have
sically, the par curve contains all the securities in a embedded call options (borrowers have
portfolio. the free option of prepaying their
The spot curve contains a single payment (usually mortgages), they are frequently evaluated
zero or strip). Some traders use the spot curve to using an OAS.
derive the Z-spread.
Asset-Backed Securities: ABS
Types of Bonds and Their frequently trade at a nominal yield
spread at their weighted average life to
Benchmark and Spread the swap curve.
Calculation
Agencies: Agencies frequently trade at
a nominal yield spread to a specific
High-Yield Bonds: High-yield bonds are usually
Treasury, such as the on-the-run 10-
priced at a nominal yield spread to a specific
year Treasury. Callable agencies are
on-the-run U.S. Treasury bond. However,
sometime evaluated based on an OAS
sometimes when the credit rating and outlook of
where the spot rate curve(s) are derived
a high-yield bond deteriorates, the bond will
from the yields on non-callable agencies.
start to trade at an actual dollar price. For
example, such a bond trades at $75.875 as
Municipal Bonds: Because of the tax
opposed to 500 basis points over the 10-year
advantages of municipal bonds (usually
Treasury.
not taxable), their yields are not as highly
correlated with U.S. Treasury yields as
Corporate Bonds: A corporate bond is
other bonds. Therefore, munis frequently
usually priced at a nominal yield
trade on an outright yield to maturity or
spread to a specific on-the-run U.S.
even a dollar price. However, a muni's
Treasury bond that matches its maturity.
yield as a ratio to a
For example, 10-year corporate bonds
benchmark Treasury yield is
are priced to the 10-year Treasury.
sometimes used as a relative value
Mortgage-Backed Securities: There are measure.
many different types of MBS. Many of
Collateralized Debt Obligations: Like the
them trade at a nominal yield spread at
MBS and ABS that frequently back CDOs,
their weighted average life to the U.S.
there are many different pricing
Treasury I-curve. Some adjustable-
benchmarks and yield measures used
rate MBS trade at a DM, others trade at
to price CDOs. The eurodollar curve is
a Z-spread. Some CMOs trade at a
sometimes used as a benchmark.
nominal yield spread to a specific
Discount margins are used on floating
 rate tranches. OAS calculations are
made for relative value analysis.
The Bottom Line
Bond pricing is really just a matter of
identifying a pricing benchmark, determining a
spread and understanding the difference
between two basic yield calculations: yield to
maturity and spot rates. With that knowledge,
understanding how various types of bonds are
priced shouldn't be intimidating.
Corporate finance guide complee
Introduction To Bonds
Companies may issue bonds to finance
operations. Most companies can borrow from
banks, but view direct borrowing from a bank as
more restrictive and expensive than selling debt
on the open market through a bond issue.
The costs involved in borrowing money directly
from a bank are prohibitive to a number of
companies. In the world of corporate finance,
many chief financial officers (CFOs) view banks
as lenders of last resort because of the restrictive
debt covenants that banks place on direct
corporate loans. Covenants are rules placed on
debt that are designed to stabilize corporate
performance and reduce the risk to which a bank
is exposed when it gives a large loan to a
company. In other words, restrictive covenants
protect the bank's interests; they're written by
securities lawyers and are based on what
analysts have determined to be risks to that
company's performance.
Here are a few examples of the restrictive
covenants faced by companies: they can't issue
any more debt until the bank loan is completely
paid off; they can't participate in any share
offerings until the bank loan is paid off; they can't
acquire any companies until the bank loan is paid
off, and so on. Relatively speaking, these are
straightforward, unrestrictive covenants that may
be placed on corporate borrowing. However, debt
covenants are often much more convoluted and
carefully tailored to fit the borrower's business
risks. Some of the more restrictive covenants
may state that the interest rate on the debt
increases substantially should the chief executive
officer (CEO) quit or if earnings per share drop in
a given time period. Covenants are a way for
banks to mitigate the risk of holding debt, but for
borrowing companies they are seen as an
increased risk.
Simply put, banks place greater restrictions on
what a company can do with a loan and are more
concerned about debt repayment than
bondholders. Bond markets tend to be more
forgiving than banks and are often seen as being
easier to deal with. As a result, companies are
more likely to finance operations by issuing
bonds than by borrowing from a bank.
What Is a Corporate Bond?
Similar to a mortgage with a bank, bonds are an
issue by a borrower to a lender. When you buy a
corporate bond, you are loaning your money to a
corporation for a predetermined period of time
(known as the maturity). In most cases, the
bond's par value is $1,000. This is the face value
of the bond and the amount the company (the
borrower) will repay the lender (you) once the
bond matures.
Of course, you're not going to loan your money
for free. The borrower must also pay you a
premium, known as a "coupon," at a
predetermined interest rate in exchange for using
your money. These interest payments are usually
made every six months until the bond reaches
maturity.
There are three important factors to consider
before buying a bond. The first is the issuer. The
second is the interest (or coupon) you will
receive. The third is the maturity date, the day
when the company must repay your principal.
Objectives and Risks
Corporate bonds offer a slightly higher yield
because they carry a higher default risk than
government bonds. Corporate bonds are not the
greatest for capital appreciation, but they do offer
an excellent source of income, especially for
retirees. Corporate bonds are also highly useful
for tax-deferred retirement savings accounts,
which allow you to avoid taxes on the semiannual
interest payments.
The risks associated with corporate bonds
depend entirely on the issuing company.
Purchasing bonds from well-established and
profitable companies is much less risky than
purchasing bonds from firms in financial trouble.
Bonds from extremely unstable companies are
called junk bonds and are very risky because
they have a high risk of default.
Strengths
Many corporate bonds offer a higher rate of
return than government bonds for only slightly
more risk.
The risk of losing your principal is very low if you
only buy bonds in well-established companies
with a good track record. This may take a bit of
research.
Weaknesses
Fixed interest payments are taxed at the same
rate as income.
Corporate bonds offer little protection against
inflation because the interest payments are
usually a fixed amount until maturity.
Three Main Uses
1. Capital Appreciation
2. Income
3. Safe Investment
How to Buy Or Sell a Corporate Bond
Corporate bonds can be purchased through a full
service or discount broker, a commercial bank or
other financial intermediaries. The best time to
buy a corporate bond is when interest rates are
relatively high.
You can also open an account with a bond
broker, but be warned that most bond brokers
require a minimum initial deposit of $5,000. If you
cannot afford this amount, we suggest looking at
a mutual fund that specializes in bonds (or
a bond fund).
If you do decide to purchase a bond through your
broker, he or she may tell you that the trade is
commission free. Don't be fooled. What typically
happens is that the broker will mark up the price
slightly; this markup is really the same as a
commission. To make sure that you are not being
taken advantage of, simply look up the latest
quote for the bond and determine whether the
markup is acceptable.
Types Of Bonds
This section describes the various types of bonds
that a company might issue. (To learn about
government-issued bonds, read
Corporate Bonds
A company can issue bonds just as it can issue
stock. Large corporations have a lot of flexibility
as to how much debt they can issue: the limit is
whatever the market will bear. Generally, a short-
term corporate bond has a maturity of less than
five years, intermediate is five to 12 years and
long term is more than 12 years.
Corporate bonds are characterized by higher
yields because there is a higher risk of a
company defaulting than a government. The
upside is that they can also be the most
rewarding fixed-income investments because of
the risk the investor must take on. The company's
credit quality is very important: the higher the
quality, the lower the interest rate the investor
receives.
Variations on corporate bonds include convertible
bonds, which the holder can convert into stock,
and callable bonds, which allow the company to
redeem an issue prior to maturity.
Convertible Bonds
A convertible bond may be redeemed for a
predetermined amount of the company's equity at
certain times during its life, usually at the
discretion of the bondholder. Convertibles are
sometimes called "CVs."
Issuing convertible bonds is one way for a
company to minimize negative investor
interpretation of its corporate actions. For
example, if an already public company chooses
to issue stock, the market usually interprets this
as a sign that the company's share price is
somewhat overvalued. To avoid this negative
impression, the company may choose to issue
convertible bonds, which bondholders will likely
convert to equity should the company continue to
do well.
From the investor's perspective, a convertible
bond has a value-added component built into it: it
is essentially a bond with a stock option hidden
inside. Thus, it tends to offer a lower rate of
return in exchange for the value of the option to
trade the bond into stock.
Callable Bonds
Callable bonds, also known as "redeemable
bonds," can be redeemed by the issuer prior to
maturity. Usually a premium is paid to the bond
owner when the bond is called.
The main cause of a call is a decline in interest
rates. If interest rates have declined since a
company first issued the bonds, it will likely want
to refinance this debt at a lower rate. In this case,
the company will call its current bonds and
reissue new, lower-interest bonds to save money.
Term Bonds
Term bonds are bonds from the same issue that
share the same maturity dates. Term bonds that
have a call feature can be redeemed at an earlier
date than the other issued bonds. A call feature,
or call provision, is an agreement that bond
issuers make with buyers. This agreement is
called an "indenture," which is the schedule and
the price of redemptions, plus the maturity dates.
Some corporate and municipal bonds are
examples of term bonds that have 10-year call
features. This means the issuer of the bond can
redeem it at a predetermined price at specific
times before the bond matures.
A term bond is the opposite of a serial bond,
which has various maturity schedules at regular
intervals until the issue is retired.
Amortized Bonds
An amortized bond is a financial certificate that
has been reduced in value for records on
accounting statements. An amortized bond is
treated as an asset, with the discount amount
being amortized to interest expense over the life
of the bond. If a bond is issued at a discount -
that is, offered for sale below its par (face value) -
the discount must either be treated as an
expense or amortized as an asset.
As we discussed in Section 4, amortization is an
accounting method that gradually and
systematically reduces the cost value of a limited
life, intangible asset. Treating a bond as an
amortized asset is an accounting method in the
handling of bonds. Amortizing allows bond
issuers to treat the bond discount as an asset
until the bond's maturity. (To learn more about
bond premium amortization, read Premium
Bonds: Problems And Opportunities.)
Adjustment Bonds
Issued by a corporation during a restructuring
phase, an adjustment bond is given to the
bondholders of an outstanding bond issue prior
to the restructuring. The debt obligation is
consolidated and transferred from the
outstanding bond issue to the adjustment bond.
This process is effectively a recapitalization of the
company's outstanding debt obligations, which is
accomplished by adjusting the terms (such as
interest rates and lengths to maturity) to increase
the likelihood that the company will be able to
meet its obligations.
If a company is near bankruptcy and requires
protection from creditors (Chapter 11), it is likely
unable to make payments on its debt obligations.
If this is the case, the company will be liquidated,
and the company's value will be spread among
its creditors. However, creditors will generally
only receive a fraction of their original loans to
the company. Creditors and the company will
work together to recapitalize debt obligations so
that the company is able to meet its obligations
and continue operations, thus increasing the
value that creditors will receive.
Junk Bonds
A junk bond, also known as a "high-yield bond" or
"speculative bond," is a bond rated "BB" or lower
because of its high default risk. Junk bonds
typically offer interest rates three to four
percentage points higher than safer government
issues.
Angel Bonds
Angel bonds are investment-grade bonds that
pay a lower interest rate because of the issuing
company's high credit rating. Angel bonds are the
opposite of fallen angels, which are bonds that
have been given a "junk" rating and are therefore
much more risky.
An investment-grade bond is rated at minimum
"BBB" by S&P and Fitch, and "Baa" by Moody's.
If the company's ability to pay back the bond's
principal is reduced, the bond rating may fall
below investment-grade minimums and become
a fallen angel.
Bond Valuation
The fundamental principle of bond valuation is interest rate used to calculate the present value.
that the bond's value is equal to the present value To figure out the value, the PV of each individual
of its expected (future) cash flows. The valuation cash flow must be found. Then, just add the
process involves the following three steps: figures together to determine the bond's price.

1. Estimate the expected cash flows.

2. Determine the appropriate interest rate or
PV at time T = expected
interest rates that should be used to discount the cash flows in period T / (1
cash flows. + I) to the T power
3. Calculate the present value of the expected
cash flows found in step one by using the interest
After you calculate the expected cash flows, you
rate or interest rates determined in step two.
will need to add the individual cash flows:

Determining Appropriate Interest Rates

The minimum interest rate that an investor should
accept is the yield for a risk-free bond (a Treasury Value = present value @
T1 + present value @ T2 +
bond for a U.S. investor). The Treasury security
present value @Tn
that is most often used is the on-the-run issue
because it reflects the latest yields and is the
most liquid. Let's throw some numbers around to further
illustrate this concept.
For non-Treasury bonds, such as corporate
bonds, the rate or yield that would be required Example: The Value of a Bond
would be the on-the-run government security rate Bond GHJ matures in five years with a coupon
plus a premium that accounts for the additional rate of 7% and a maturity value of $1,000. For
risks that come with non-Treasury bonds. simplicity's sake, let's assume that the bond pays
annually and the discount rate is 5%.
As for the maturity, an investor could just use the
final maturity date of the issue compared to the The cash flow for each of the years is as follows:
Treasury security. However, because each cash Year One = $70
flow is unique in its timing, it would be better to
use the maturity that matches each of the Year Two = $70
individual cash flows.
Year Three = $70
Computing a Bond's Value
First, we need to find the present value (PV) of Year Four = $70
the bond's future cash flows. The present value is
the amount that would have to be invested today Year Five = $1,070
to generate that future cash flow. PV is
dependent on the timing of the cash flow and the Thus, the PV of the cash flows is as follows:
Year One = $70 / (1.05) to the 1st power = $66.67
nd
Year Two = $70 / (1.05) to the 2 power = $
63.49
Year Three = $70 / (1.05) to the 3rd power = $
60.47
Year Four = $70 / (1.05) to the 4th power = $
57.59
Year Five = $1,070 / (1.05) to the 5th power = $
838.37
Now to find the value of the bond:
Value = $66.67 + $63.49 + $60.47 + $57.59 +
$838.37
Value = $1,086.59
How Does the Value of a Bond Change?
As rates increase or decrease, the discount rate
that is used also changes. Let's change the
discount rate in the above example to 10% to see
how it affects the bond's value.
Example: The Value of a Bond when Discount
Rates Change
PV of the cash flows is:
Year One = $70 / (1.10) to the 1st power = $
63.63
Year Two = $70 / (1.10) to the 2nd power = $
57.85
rd
Year Three = $70 / (1.10) to the 3 power = $
52.63
th
Year Four = $70 / (1.10) to the 4 power = $
47.81
Year Five = $1,070 / (1.10) to the 5th power = $
664.60
Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60
= $ 886.52
As we can see from the above examples,
an important property of PV is that for a
given discount rate, the older a cash flow
value is, the lower its present value.
We can also compute the change in value
from an increase in the discount rate used
in our example. The change = $1,086.59 -
$886.52 = $200.07.
Another property of PV is that the higher
the discount rate, the lower the value of a
bond; the lower the discount rate, the
higher the value of the bond.
Look Out!
If the discount rate is higher
than the coupon rate the PV
will be less than par. If the
discount rate is lower than the
coupon rate, the PV will be
higher than par value.
How Does a Bond's Price Change as it
Approaches its Maturity Date?
As a bond moves closer to its maturity date, its
price will move closer to par. There are three
possible scenarios:
1.If a bond is at a premium, the price will decline
over time toward its par value.
2. If a bond is at a discount, the price will
increase over time toward its par value.
3. If a bond is at par, its price will remain the
same.
To show how this works, let's use our original
example of the 7% bond, but now let's assume
that a year has passed and the discount rate
remains the same at 5%.
Example: Price Changes Over Time
Let's compute the new value to see how the price
moves closer to par. You should also be able to
see how the amount by which the bond price
changes is attributed to it being closer to its
maturity date.
PV of the cash flows is:
Year One = $70 / (1.05) to the 1st power = $66.67
Year Two = $70 / (1.05) to the 2nd power = $
63.49
Year Three = $70 / (1.05) to the 3rd power = $
60.47
Year Four = $1,070 / (1.05) to the 4th power =
$880.29
Value = $66.67 + $63.49 + $60.47 + $880.29 =
$1,070.92
As the price of the bond decreases, it moves
closer to its par value. The amount of change
attributed to the year's difference is $15.67.
An individual can also decompose the change
that results when a bond approaches its maturity
date and the discount rate changes. This is
accomplished by first taking the net change in the
price that reflects the change in maturity, then
adding it to the change in the discount rate. The
two figures should equal the overall change in the
bond's price.
Computing the Value of a Zero-coupon Bond
A zero-coupon bond may be the easiest of
securities to value because there is only one
cash flow - the maturity value.
The formula to calculate the value of a zero
coupon bond that matures N years from now is
as follows:
Maturity value / (1 + I) to
the power of the number of
years * 2
Where I is the semi-annual
discount rate.
Example: The Value of a Zero-Coupon Bond
For illustration purposes, let's look at a zero
coupon with a maturity of three years and a
maturity value of $1,000 discounted at 7%.
I = 0.035 (.07 / 2)
N=3
Value of a Zero-Coupon Bond
= $1,000 / (1.035) to the 6th power (3*2)
= $1,000 / 1.229255
= $813.50
Arbitrage-free Valuation Approach
Under a traditional approach to valuing a bond, it
is typical to view the security as a single package
of cash flows, discounting the entire issue with
one discount rate. Under the arbitrage-free
valuation approach, the issue is instead viewed
as various zero-coupon bonds that should be
valued individually and added together to
determine value. The reason this is the correct
way to value a bond is that it does not allow a
risk-free profit to be generated by "stripping" the
security and selling the parts at a higher price
than purchasing the security in the market.
As an example, a five-year bond that pays semi-
annual interest would have 11 separate cash
flows and would be valued using the appropriate
yield on the curve that matches its maturity. So
the markets implement this approach by
determining the theoretical rate the U.S. Treasury
would have to pay on a zero-coupon treasury for
each maturity. The investor then determines the
value of all the different payments using the
theoretical rate and adds them together. This
zero-coupon rate is the Treasury spot rate. The
value of the bond based on the spot rates is the
arbitrage-free value.
offering higher coupon rates, so yields will
have to increase, which means the bond
price will drop to induce investors to
purchase these bonds. Remember that
as yields increase, bond prices fall.

Determining Whether a Bond Is Under or Over

Bonds rating:
Valued
A bond rating is a grade given to a bond that
What you need to be able to do is value a bond
indicates its credit quality. Private independent
like we have done before using the more
rating services provide these evaluations of a
traditional method of applying one discount rate
bond issuer's financial strength or its ability to pay
to the security. The twist here, however, is that
a bond's principal and interest in a timely fashion.
instead of using one rate, you will use whatever
Bond ratings are expressed as letters ranging
rate the spot curve has that coordinates with the
from "AAA," which is the highest grade, to "C" or
proper maturity. You will then add the values up
"D" ("junk"), which is the lowest grade. Different
as you did previously to get the value of the bond.
rating services use the same letter grades, but
use various combinations of upper and lower-
You will then be given a market price to compare
case letters to differentiate themselves.
to the value that you derived from your work. If
the market price is above your figure, then the
The bond rating system helps investors
bond is undervalued and you should buy the
determine a company's credit risk. Think of a
issue. If the market price is below your price, then
bond rating as the report card for a company's
the bond is overvalued and you should sell the
credit rating. Blue-chip firms, which are safer
issue.
investments, have a high rating, while risky
companies have a low rating. The chart below
How Bond Coupon Rates and Market Rates
illustrates the different bond rating scales from
Affect Bond Price
the major rating agencies in the United States:
If a bond's coupon rate is above the yield
Moody's, Standard and Poor's and Fitch Ratings.
required by the market, the bond will trade above
its par value or at a premium. This will occur
because investors will be willing to pay a higher
Bond Rating
price to achieve the additional yield. As investors
Moody\'s S&P/ Fitch Grade Risk
continue to buy the bond, the yield will decrease
until it reaches market equilibrium. Remember Highest
AAA Investment
Quality
that as yields decrease, bond prices rise.
AA Investment High Qua
If a bond's coupon rate is below the yield
A Investment Strong
required by the market, the bond will trade
below its par value or at a discount. This BBB Investment Medium G
happens because investors will not buy
BB, B Junk Speculati
this bond at par when other issues are
 Highly make investment decisions. Rating agencies play
a/C CCC/CC/C Junk
Speculative
D Junk
In Default
Notice that if the company falls below a certain
credit rating, its grade changes from investment
quality to junk status. Junk bonds are aptly
named: they are the debt of companies in some
sort of financial difficulty. Because these bonds
are so risky, they have to offer much higher yields
than any other debt. Bonds are not inherently
safer than stocks. Certain types of bonds can be
just as risky, if not riskier, than stocks.
Rating the creditworthiness of a bond issuer,
despite the number crunching, is as much an art
form as it is a science. While companies
like Moody's and A.M. Best gather and analyze
mountains of data, the rating itself comes down
to the informed opinion of an analyst or a rating
committee.
The organizations that rate bonds look at an
issuer's assets, debts, income, expenses and
financial history. In addition, they give special
attention to the trustworthiness of a company to
repay previous bond issues on time and in full.
Rating agencies regularly review bond ratings
every six to 12 months. However, a bond may be
reviewed at any time the agency deems
necessary for reasons including missed or
delayed payments to investors, issuance of new
bonds, changes to an issuer's underlying
financial fundamentals, or other broad economic
developments. (For more on this subject,
read The Debt Ratings Debate.)
Institutional and individual investors rely on bond
rating agencies and their in-depth research to
an integral role in the investment process and
can make or break a company's success in both
the primary and secondary bond markets. While
the rating agencies provide a robust service and
are worth the fees they earn, the value of such
ratings has been widely questioned since the
2008 financial crisis, and the agencies' timing
and opinions have been criticized when dramatic
downgrades have come very quickly.
Investors should not rely solely on the bond rating
agency's rating and should supplement the
ratings with their own research. It's also important
to frequently review the ratings over the life of a
bond. (Read more in Bond Rating Agencies: Can
You Trust Them? and Why Bad Bonds Get Good
Ratings.)
Occasionally, firms will not have their bonds
rated, in which case it is solely up to the investor
to judge a firm's repayment ability. Because the
rating systems differ for each agency and change
from time to time, it is prudent to research the
rating definition for the bond issue you are
considering.
Bond market
The bond market is where debt securities are
issued and traded. The bond market primarily
includes government-issued securities and
corporate debt securities, and it facilitates the
transfer of capital from savers to the issuers or
organizations that requires capital for government
projects, business expansions and ongoing
operations. The bond market is alternatively
referred to as the debt, credit or fixed-income
market. Although the bond market appears
complex, it is really driven by the same risk and
return tradeoffs as the stock market. Most trading
in the bond market occurs over the counter
through organized electronic trading networks
and is composed of the primary market (through
which debt securities are issued and sold by
borrowers to lenders) and the secondary market
(through which investors buy and sell previously
issued debt securities among themselves).
Although the stock market often commands more
media attention, the bond market is actually many
times bigger and is vital to the ongoing operation
of the public and private sectors.
The bond market can essentially be broken down
into three main groups: issuers, underwriters and
purchasers.
The issuers sell bonds or other debt instruments
in the bond market to fund the operations of their
organizations. This area of the market is mostly
made up of governments, banks and
corporations. The biggest of these issuers is the
government, which uses the bond market to help
fund a country's operations. Banks are also key
issuers in the bond market, and they can range
from local banks up to supranational banks such
as the European Investment Bank. The final
major issuer is the corporate bond market, which
issues debt to finance corporate operations.
The underwriting segment of the bond market is
traditionally made up of investment banks and
other financial institutions that help the issuer to
sell the bonds in the market. In general, selling
debt is not as easy as just taking it to the market.
In most cases, millions if not billions of dollars are
transacted in one offering. As a result, a lot of
work needs to be done to prepare for the offering,
such as creating a prospectus and other legal
documents. In general, the need for underwriters
is greatest for the corporate debt market because
there are more risks associated with this type of
debt.
The final players in the bond market are those
who buy the debt. Buyers basically include every
group mentioned as well as any other type of
investor, including the individual. Governments
play one of the largest roles in the market
because they borrow and lend money to other
governments and banks. Furthermore,
governments often purchase debt from other
countries if they have excess reserves of that
country's money as a result of trade between
countries. For example, Japan is a major holder
of U.S. government debt.
Getting bond quotes and general information
about a bond issue is considerably more difficult
than researching a stock or a mutual fund. There
is not a lot of individual investor demand for the
information; most bond information is available
only through higher level tools that are not
accessible to the average investor.
In most cases, if you have a brokerage account,
you will have access to that firm's research tools,
which may include bond quotes and other
information. Your brokerage is therefore the first
place that you should look for bond information.
However, there are also free tools available
online that provide some basic information such
as the bond's current price, coupon rate, yield to
maturity (YTM), bond rating and other pertinent
information. Online services can be limited,
however, if they do not give you the volume of
bonds that trade hands or a bid-ask spread,
making it difficult to measure the true price of the
bond.

How Inflation And Interest
Rates Affect Bonds
Ownership of a bond is the ownership of a
stream of future cash payments. Those cash
payments are usually made in the form of
periodic interest payments and the return
of principal when the bond matures. In the
absence of credit risk (the risk of default), the
value of that stream of future cash payments is
simply a function of your required return based
on your inflation expectations. In this section we'll
break down bond pricing, define the term
"bond yield" and demonstrate how inflation
expectations and interest rates determine the
value of a bond.
Measures of Risk
There are two primary risks that must be
assessed when investing in bonds: interest rate
risk and credit risk. Though our focus is on
how interest rates affect bond pricing, otherwise
known as interest rate risk, it's also important that
a bond investor be aware of credit risk.
(Read Managing Interest Rate Risk to learn more
about the risk that comes with changing rates.)
Interest rate risk is the risk of changes in a bond's
price due to changes in prevailing interest rates.
Changes in short-term versus long-term interest
rates can affect various bonds in different ways,
which we'll soon discuss.
Credit risk, meanwhile, is the risk that the bond's
issuer will not make scheduled interest and/or
principal payments. The probability of a negative
credit event or default affects a bond's price. The
higher the risk of a negative credit event
occurring, the higher the interest rate investors
will demand for assuming that risk.
In this section, we'll focus on interest-rate risk.
(To learn about credit risk, read Corporate
Bonds: An Introduction To Credit Risk.)
Calculation of a Bond's Yield and Price
To understand how interest rates affect a bond's
price, you must understand the concept of yield.
While there are several different types of yield
calculations, for the purposes of this article we
will use the yield-to-maturity (YTM) calculation. A
bond's YTM is simply the discount rate that can
be used to make the present value of all of a
bond's cash flows equal to its price. In other
words, a bond's price is the sum of the present
value of each cash flow where the present value
of each cash flow is calculated using the same
discount factor. This discount factor is the yield.
When a bond's yield rises, by definition, its price
falls, and when a bond's yield falls, by definition,
its price increases. (To learn more on this
concept, be sure to read Get Acquainted With
Bond Price/Yield Duo.)
A Bond's Relative Yield
The maturity or term of a bond largely affects its
yield. To understand this statement, you must
understand what is known as the yield curve. The
yield curve represents the YTM of a class of
bonds (in this case U.S. Treasury bonds). In most
interest rate environments, the longer the term to
maturity, the higher the yield will be. This should
make intuitive sense because the longer the
period of time before a cash flow is received, the
more chance there is that the required discount
rate (or yield) will move higher. (Be sure to
read Bond Yield Curve Holds Predictive
Powers to learn more about this measure of
economic activity, inflation levels and interest rate
expectations.)
Inflation Expectations Determine Investors'
Yield Requirements
Inflation is a bond's worst enemy. Inflation erodes
the purchasing power of a bond's future cash
flows. Put simply, the higher the current rate of
inflation and the higher the (expected) future
rates of inflation, the higher the yields will rise
across the yield curve, as investors will demand
this higher yield to compensate for inflation risk.
Short-Term and Long-Term Interest Rates, and
Inflation Expectations
Inflation - and expectations of future inflation - are
a function of the dynamics between short-term
and long-term interest rates. Worldwide, short-
term interest rates are administered by nations'
central banks. In the United States, the Federal
Reserve Board's Open Market
Committee (FOMC) sets the federal funds rate.
Historically, other dollar-denominated short-term
interest rates such as LIBOR are highly
correlated with the fed funds rate. The FOMC
administers the fed funds rate to fulfill its dual
mandate of promoting economic growth while
maintaining price stability. This is not an easy
task for the FOMC; there is always much debate
about the appropriate fed funds level, and the
market forms its own opinions on how well the
FOMC is doing.
Central banks do not control long-term interest
rates. Market forces (supply and demand)
determine equilibrium pricing for long-term
bonds, which set long-term interest rates. If the
bond market believes that the FOMC has set the
fed funds rate too low, expectations of future
inflation increase, which means long-term interest
rates increase relative to short-term interest rates
- the yield curve gets steeper. If the market
believes that the FOMC has set the fed funds
rate too high, the opposite happens, and long-
term interest rates decrease relative to short-term
interest rates, flattening the yield curve.
(Whenever you hear the latest inflation update on
the news, chances are that interest rates are
mentioned in the same breath. Read the Inflation
And Interest Rates section of our Inflation
Tutorial to learn more about their relationship.)
The Timing of a Bond's Cash Flows and
Interest Rates
The timing of a bond's cash flows is important.
This includes the bond's term to maturity. If
market participants believe that there is higher
inflation on the horizon, interest rates and bond
yields will rise (and prices will decrease) to
compensate for the loss of the purchasing power
of future cash flows. Those bonds with the
longest cash flows will see their yields rise and
prices fall the most. This should be intuitive if you
think about a present value calculation - when
you change the discount rate used on a stream of
future cash flows, the longer until a cash flow is
received, the more its present value is affected.
The bond market has a measure of price change
relative to interest rate changes; this important
bond metric is known as duration. (To learn more
about duration, be sure to check out
the Duration section of our Advanced Bond
Concepts Tutorial.)
Summing It Up
Interest rates, bond yields (prices) and inflation
expectations have a correlation to each other.
Movements in short-term interest rates, as
dictated by a nation's central bank, will affect
different bonds with different terms to maturity
differently depending on the market's
expectations of future levels of inflation.
For example, a change in short-term interest
rates that does not affect long-term interest rates
will have little effect on a long-term bond's price
and yield. However, a change (or no change
when the market perceives that one is needed) in
short-term interest rates that affects long-term
interest rates can greatly affect a long-term
bond's price and yield. Put simply, changes in
short-term interest rates have more of an effect
on short-term bonds than long-term bonds, and
changes in long-term interest rates have an effect
on long-term bonds, but not short-term bonds.
The key to understanding how a change in
interest rates will affect a certain bond's price and
yield is to recognize where on the yield curve that
bond lies (the short end or the long end) and to
understand the dynamics between short- and
long-term interest rates. With this knowledge, you
can use different measures of duration
and convexity to become a seasoned bond
market investor.
Duration
Bond duration is a measure of the sensitivity
of the price (the value of principal) of a fixed-
income investment to a change in interest
rates. Duration is expressed as a number of
years. Rising interest rates mean falling bond
prices, while declining interest rates mean
rising bond prices.
The duration number is a complicated
calculation involving present value, yield,
coupon, final maturity and call features.
The bigger the duration number, the greater
the interest-rate risk or reward for bond
prices.
It is a common misconception among non-
professional investors that bonds and bond
funds are risk-free. They are not. As you
learned in the last section, investors need to be
aware of two main risks that can affect a
bond's investment value:
-credit risk (default) and interest rate risk (rate
fluctuations). The duration indicator addresses
the latter issue.
The term duration has a special meaning in the
context of bonds. It is a measurement of how
long, in years, it takes for the price of a bond
to be repaid by its internal cash flows. It is an
important measure for investors to consider, as
bonds with higher durations carry more risk
and have higher price volatility than bonds
with lower durations.
For each of the two basic types of bonds the
duration is the following:
1. Zero-Coupon Bond - Duration is equal to its
time to maturity.
2. Vanilla Bond - Duration will always be less
than its time to maturity.
Let's first work through some visual models that
demonstrate the properties of duration for a zero-
coupon bond and a vanilla bond.
Duration of a Zero-Coupon Bond

The red lever above represents the four-year time
period it takes for a zero-coupon bond to mature.
The money bag balancing on the far right
represents the future value of the bond - the
amount that will be paid to the bondholder at
maturity. The fulcrum, or the point holding the
lever, represents duration, which must be
positioned where the red lever is balanced. The
fulcrum balances the red lever at the point on the
time line at which the amount paid for the bond
and the cash flow received from the bond are
equal. The entire cash flow of a zero-coupon
bond occurs at maturity, so the fulcrum is located
directly below this one payment.
Duration of a Vanilla or Straight Bond
Consider a vanilla or straight bond that pays
coupons annually and matures in five years. Its
cash flows consist of five annual coupon
payments and the last payment includes the face
value of the bond.
The money bags represent the cash flows you
will receive over the five-year period. To balance
the red lever at the point where total cash
flows equal the amount paid for the bond, the
fulcrum must be farther to the left, at a point
before maturity.
Factors Affecting Duration
It is important to note, however, that duration
changes ans the coupons are paid to the
bondholder. As the bondholder receives a
coupon payment, the amount of the cash flow
is no longer on the time line, which means it
is no longer counted as a future cash flow that
goes towards repaying the bondholder. Our
model of the fulcrum demonstrates this: as the
first coupon payment is removed from the red
lever and paid to the bondholder, the lever is
no longer in balance because the coupon
payment is no longer counted as a future cash
flow.
The fulcrum must now move to the right in
order to balance the lever again:
 The formula for Macaulay duration is as
follows:

n = number of cash flows

t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price

Duration: Other Factors

Remember that bond price equals:
Besides the movement of time and the
payment of coupons, there are other factors
that affect a bond's duration, including the
coupon rate and its yield. Bonds with high
coupon rates and, in turn, high yields will tend
to have lower durations than bonds that pay So the following is an expanded version of
low coupon rates or offer low yields. This Macaulay duration:
makes empirical sense, because when a bond
pays a higher coupon rate or has a high yield,
the holder of the security receives repayment
for the security at a faster rate.

Types of Duration
There are four main types of duration
Example 1: Betty holds a five-year bond with
calculations, each of which differ in the way a par value of $1,000 and coupon rate of 5%.
they account for factors such as interest rate For simplicity, let's assume that the coupon is
changes and the bond's embedded options or paid annually and that interest rates are 5%.
redemption features. The four types of What is the Macaulay duration of the bond?
durations are Macaulay duration, modified
duration, effective duration and key-rate
duration.

Macaulay Duration
The formula usually used to calculate
a bond\'s basic duration is the
Macaulay duration, is calculated by
adding the results of multiplying the
present value of each cash flow by
the time it is received and dividing
by the total price of the security.

= 4.55 years
Fortunately, if you are seeking the Macaulay
duration of a zero-coupon bond, the
duration would be equal to the bond's
maturity, so there is no calculation required.
Modified Duration
Modified duration is a modified version of
the Macaulay model that accounts for
changing interest rates. Because they affect
yield, fluctuating interest rates will affect
duration, so this modified formula shows how
much the duration changes for each
percentage change in yield. For bonds
without any embedded features, bond price
and interest rate move in opposite
directions, so there is an inverse relationship
between modified duration and an
approximate 1% change in yield. Because
the modified duration formula shows how a
bond's duration changes in relation to
interest rate movements, the formula is
appropriate for investors wishing to measure
the volatility of a particular bond. Modified
duration is calculated as the following:
OR
Let's continue to analyze Betty's bond and run
through the calculation of her modified
duration. Currently her bond is selling at
$1,000, or par, which translates to a yield to
maturity of 5%. Remember that we
calculated a Macaulay duration of 4.55.
= 4.33 years
Our example shows that if the bond's yield
changed from 5% to 6%, the duration of the
bond will decline to 4.33 years. Because it
calculates how duration will change when
interest increases by 100 basis points, the
modified duration will always be lower than
the Macaulay duration.
Effective Duration
The modified duration formula discussed
above assumes that the expected cash flows
will remain constant, even if prevailing
interest rates change; this is also the case for
option-free fixed-income securities. On the
other hand, cash flows from securities with
embedded options or redemption features will
change when interest rates change. For
calculating the duration of these types of
bonds, effective duration is the most
appropriate method.
Effective duration requires the use of binomial
trees to calculate the option-adjusted
spread (OAS). There are entire courses built
around just those two topics, so the
calculations involved for effective duration are
beyond the scope of this section. There are,
however, many programs available to investors
wishing to calculate effective duration.
Key-Rate Duration
The final duration calculation to learn is key-
rate duration, which calculates the spot
durations of each of the 11 "key" maturities
 along a spot rate curve. These 11 key
maturities are at the three-month and one, two,
three, five, seven, 10, 15, 20, 25, and 30-year
portions of the curve.
In essence, key-rate duration, while holding
the yield for all other maturities constant,
allows the duration of a portfolio to be
calculated for a one-basis-point change in
interest rates. The key-rate method is most
often used for portfolios such as the bond
ladder, which consists of fixed-income
securities with differing maturities. Here is the
formula for key-rate duration:
The sum of the key-rate durations along the
curve is equal to the effective duration.
Duration and Bond Price Volatility
We have established that when interest rates
rise, bond prices fall, and vice versa. But how
does one determine the degree of a price change
when interest rates change? Generally, bonds
with a high duration will have a higher price
fluctuation than bonds with a low duration. But it
is important to know that there are also three
other factors that determine how sensitive a
bond's price is to changes in interest rates. These
factors are term to maturity, coupon rate
and yield to maturity. Knowing what affects a
bond's volatility is important to investors who use
duration-based immunization strategies, which
we discuss below, in their portfolios.
Factors 1 and 2: Coupon Rate and
Term to Maturity
If term to maturity and a bond\'s initial
price remain constant, the higher the
coupon, the lower the volatility, and the
lower the coupon, the higher the
volatility. If the coupon rate and the
bond\'s initial price are constant, the
bond with a longer term to maturity will
display higher price volatility and a bond
with a shorter term to maturity will
display lower price volatility.
Therefore, if you would like to invest in a
bond with minimal interest rate risk, a
bond with high coupon payments and a
short term to maturity would be optimal.
An investor who predicts that interest
rates will decline would best potentially
capitalize on a bond with low coupon
payments and a long term to maturity,
since these factors would magnify a
bond\'s price increase.
Factor 3: Yield to Maturity (YTM)
The sensitivity of a bond\'s price to
changes in interest rates also depends
on its yield to maturity. A bond with a
high yield to maturity will display lower
price volatility than a bond with a lower
yield to maturity, but a similar coupon
rate and term to maturity. Yield to
maturity is affected by the bond\'s credit
rating, so bonds with poor credit ratings
will have higher yields than bonds with
excellent credit ratings. Therefore,
bonds with poor credit ratings typically
display lower price volatility than bonds
with excellent credit ratings.
All three factors affect the degree to which bond
price will be altered in the face of a change in
prevailing interest rates. These factors work
together and against each other.
So, if a bond has both a short term to maturity
and a low coupon rate, its characteristics have
opposite effects on its volatility: the low coupon
raises volatility and the short term to maturity
lowers volatility. The bond's volatility would then
be an average of these two opposite effects.
Immunization
As we mentioned in the above section, the
interrelated factors of duration, coupon rate, term
to maturity and price volatility are important for
those investors employing duration-based
immunization strategies. These strategies aim to
match the durations of assets and liabilities within
a portfolio for the purpose of minimizing the
impact of interest rates on the net worth. To
create these strategies, portfolio managers use
Macaulay duration.
to maturity. The statistic that aids investors in
both areas is duration. Read on to find out how
duration and convexity can help fixed-income
investors gauge uncertainty when managing their
portfolios. (For background reading, check out
our Advanced Bond Concepts tutorial.)

For example, say a bond has a two-year term Duration Defined

with four coupons of $50 and a par value of In 1938, Frederick Macaulay termed the effective-
$1,000. If the investor did not reinvest his or her maturity concept the duration of thebond, and
proceeds at some interest rate, he or she would suggested that duration be computed as
have received a total of $1,200 at the end of two the weighted average of the times to each
years. However, if the investor were to reinvest coupon or principal payment made by the
each of the bond cash flows until maturity, he or bond. Macaulay's duration formula is as follows:
she would have more than $1,200 in two years.
Therefore, the extra interest accumulated on the
reinvested coupons would allow the bondholder
to satisfy a future $1,200 obligation in less time
than the maturity of the bond.

Understanding what duration is, how it is used

and what factors affect it will help you to
determine a bond's price volatility. Volatility is an
important factor in determining your strategy for D is the bond's duration
capitalizing on interest rate movements.
Furthermore, duration will also help you to C is the periodic coupon payment
determine how you can protect your portfolio from
F is the face value at maturity (in dollars)
interest rate risk.

T is the number of periods until maturity

Use Duration And Convexity
r is the periodic yield to maturity
To Measure Bond Risk
t is the period in which the coupon is
A coupon bond makes a series of payments over received
its life, so fixed-income investors need a measure
Duration for Portfolio Management
of the average maturity of the bond's promised
cash flow to serve as a summary statistic of the Duration is key in fixed-income portfolio

effective maturity of the bond. Also needed is a management for the following three reasons:

measure that could be used as a guide to

1. It is a simple summary statistic of the
the sensitivity of a bond to interest rate changes,
effective average maturity of a portfolio.
since price sensitivity tends to increase with time
 2. It is an essential tool
in immunizing portfolios from interest rate
risk.
3. Duration is an estimate of the interest rate
sensitivity of a portfolio.
Because duration is so important to fixed-income
portfolio management, it is worth exploring the
following properties:
The duration of a zero-coupon
bond equals its time to maturity.
Holding maturity constant, a bond's
duration is lower when the coupon rate is
higher. This rule is due to the impact of
early higher coupon payments.
Holding the coupon rate constant, a
bond's duration generally increases with
time to maturity. This property of duration
is fairly intuitive; however, duration does
not always increase with time to maturity.
For some deep-discount bonds, duration
may fall with increases in maturity.
Holding other factors constant, the
duration of a coupon bond is higher when
the bond's yield to maturity is lower. This
principle applies to coupon bonds. For
zero-coupon bonds, duration equals time
to maturity, regardless of the yield to
maturity.
The duration of a level perpetuity is (1 +
y)/y. For example, at a 10% yield, the
duration of perpetuity that pays $100 once
a year forever will equal 1.10/.10 = 11
years, but at an 8% yield it will equal
1.08/.08 = 13.5 years. This principle
makes it obvious that maturity and
duration can differ substantially. The
maturity of the perpetuity is infinite,
whereas the duration of the instrument at
a 10% yield is only 11 years. The present-
value-weighted cash flow early on in the
life of the perpetuity dominates the
computation of duration. (For more
information on portfolio management,
read Equity Portfolio Management
Mechanics and Preparing For A Career
As A Portfolio Manager.)
Duration for Gap Management
Many banks have a natural mismatch between
asset and liability maturities. Bank liabilities are
primarily the deposits owed to customers, most of
which are very short-term in nature and of low
duration. Bank assets by contrast are composed
largely of outstanding commercial and consumer
loans or mortgages. These assets are of longer
duration and their values are more sensitive to
interest rate fluctuations. In periods when interest
rates increase unexpectedly, banks can suffer
serious decreases in net worth if their assets fall
in value by more than their liabilities.
To manage this risk, a technique
called gap management became popular in the
1970s and early 1980s, with the idea being to
limit the "gap" between asset and liability
durations. Adjustable-rate mortgages (ARM)
were one way to reduce the duration of bank-
asset portfolios. Unlike conventional mortgages,
ARMs do not fall in value when market rates
increase because the rates they pay are tied to
the current interest rate. Even if the indexing is
imperfect or entails lags, it greatly diminishes
sensitivity to interest rate fluctuations. On the
other side of the balance sheet, the introduction
of longer-term bank certificates of deposit (CD)
with fixed terms to maturity served to lengthen
the duration of bank liabilities, also reducing the
duration gap. (Learn more about financial gaps
in Playing The Gap.)
One way to view gap management is as an
attempt by the bank to equate the durations of
assets and liabilities to effectively immunize its
overall position from interest rate movements.
Because bank assets and liabilities are roughly
equal in size, if their durations are also equal, any
change in interest rates will affect the value of
assets and liabilities equally. Interest rate
changes would have no effect on net worth.
Therefore, net worth immunization requires a
portfolio duration, or gap, of zero. (To learn more
about bank assets and liabilities, read Analyzing
A Bank's Financial Statements.)
statistic calculates a linear relationship between
price and yield changes in bonds. In reality, the
relationship between the changes in price and
yield is convex. In Figure 1, the curved line
represents the change in prices given a change
in yields. The straight line, tangent to the curve,
represents the estimated change in price via the
duration statistic. The shaded area shows the
difference between the duration estimate and the
actual price movement. As indicated, the larger
the change in interest rates, the larger the error in
estimating the price change of the bond.

Institutions with future fixed obligations, such

as pension funds and insurance companies, are
different from banks in that they think more in
terms of future commitments. Pension funds, for
example, have an obligation to provide workers
with a flow of income upon retirement and must
have sufficient funds available to meet this
commitment. As interest rates fluctuate, both the
value of the assets held by the fund and the rate
at which those assets generate income fluctuate. Figure 1
The portfolio manager, therefore, may want to Convexity, which is a measure of the curvature of
protect (immunize) the future accumulated the changes in the price of a bond in relation to
value of the fund at some target date against changes in interest rates, is used to address this
interest-rate movements. The idea behind error. Basically, it measures the change in
immunization is that with duration-matched duration as interest rates change. The formula is
assets and liabilities, the ability of the asset as follows:
portfolio to meet the firm's obligations should be
unaffected by interest rate movements. (Read
more about pension funds' obligations
in Analyzing Pension Risk.)

Convexity
Unfortunately, duration has limitations when used
C is convexity
as a measure of interest rate sensitivity. The
 B is the bond price
r is the interest rate
d is duration
In general, the higher the coupon, the lower the
convexity - a 5% bond is more sensitive to
interest rate changes than a 10% bond. Because
of the call feature, callable bonds will
display negative convexity if yields fall too low,
meaning the duration will decrease when yields
decrease. (To read about some risks associated
with callable and other bonds, read Call
Features: Don't Get Caught Off
Guard and Corporate Bonds: An Introduction To
Credit Risk.)
Conclusion
Interest rates are constantly changing and add a
level of uncertainty to fixed-income investing.
Duration and convexity allow investors to quantify
this uncertainty and are useful tools in the
management of fixed-income portfolios.
Duration
Duration measures a fixed-incomes sensitivity to
changes in interest rates.
Duration is a complicated calculation, but its
standard information thats provided with bonds
and bond mutual funds. It essentially reveals how
long it will take for the interest payments
generated by a fixed-income investment to repay
the invested principal. Its expressed as a number
of years.
Investors need to remember that investing in
bonds poses credit risk and interest rate risk.
Duration indicates how much risk a bond investor
faces from changes in interest rates.
A bond with a higher duration will have a lower
coupon rate, along with a longer term to maturity
and more volatility. This makes it more vulnerable
to interest rate risk.
If Susan owns a bond with a duration of five, it
will take five years for Susan to receive her
principal back. If interest rates rise by 1%, the
bond will decrease in value by 5%. A 1%
decrease in interest rates means Susans bond
will increase in value by 5%.
If Susan and John own bonds with similar
maturities, the bond paying the highest coupon
will have the shortest duration. If their bonds have
the same coupon rate, the bond that matures first
will have the shortest duration.
Finally, if Johns bond has a duration of 10 and
interest rates change, its price will experience a
bigger change than Susans because of its higher
duration.
Immunization Inoculates
Against Interest Rate Risk
If you invest in bonds, currencies or
fixed securities you know that changes in interest
rates can quickly turn your dreams of profit into a
nightmare. Imagine being a huge investment
bank with billions of dollars on the line and you
can understand how losses can really pile up!
So how do these major players hedge their
interest rate risk? One available strategy is
interest rate immunization. (For background
reading, see Advanced Bond Concepts.)
Why Do Interest Rates Matter?
Bonds and other fixed securities have two main
types of risk: interest rate risk and credit risk. To
measure interest rate risk, we use a concept
called duration, a measure of how sensitive the
price of a bond is to changes in interest rates.
The longer a bond's maturity, the greater its
duration and yield swings. If interest rates go up,
bond prices will go down. For a portfolio of
bonds, this means that increases in interest rates
lower the portfolio's value.
Figure 1
Copyright coupons are received), the present
value of cash flows and the future value.
However, even after analyzing countless
scenarios through complex mathematical
formulas, a large number of variables can react in
unexpected ways.
What Is Interest Rate Immunization?
Interest rate immunization is a hedging strategy
that seeks to limit or offset the effect that changes
in interest rates can have on a portfolio or fixed
security. Immunization strategies
use derivatives and other financial instruments to
offset as much risk as possible when it comes to
interest rates. In order to immunize an investment
or portfolio, you need to understand two things:
duration and convexity. (For background reading,
see Use Duration And Convexity To Measure
Risk.)
Duration and Convexity: The Basics
Duration
Duration is the sensitivity of the price of a bond or
bond portfolio to a change in interest rates. (In
this article we operate under the assumption that
only parallel shifts in the interest rate occur. In
fact, rates can also twist, tilt or bend ). In general,
as a bond's maturity increases, so will its
duration. Duration is the same as maturity
for zero-coupon bonds. The basic formula for
duration is:
Where:
D = Duration
P = Bond\'s market value
r = Interest rate
and D are the Greek
symbol delta, meaning
"change".
It can be approximated to:
This shows that a bond with a duration of four
years will decline in value 4% for each 1%
increase in interest rates. (Remember that bond
prices and interest rates move in opposite
directions.) A bond with a duration of two years
would decline by 2% for every 1% increase in
interest rates. Thus, bonds with longer durations
are more sensitive to fluctuations in interest rates.
 (For more on this, read Advanced Bond
Concepts: Duration.)

If a bond has fixed cash flow payments,

the Macaulay formula for duration is used. The
formula is a weighted average of the cash flows.

Where:
Dm = Macaulay duration
t = How often payment is
received
T = Number of periods
until final maturity
Figure 2
= Bond principal or
payment Copyright 2009 Investopedia.com
PV= Present
value calculation r = Change in the interest rate
To calculate the duration of a bond portfolio, pyou
= A change in a portfolio's value or investment's price
can take a weighted average of each
component's duration. Example - Calculating the Convexity of a Bond Portfolio

- Calculating the Duration of a Bond Portfolio

Convexity (seen as the blue curve in Figure 2 above) is the curve to w
hat a bond has a $10,000 face value and a 6% coupon. The
duration line is tangent. It is the rate at which prices rise as yields fal
s 5% and it matures in three years. The bond thus pays $600 a year
calculated in squared time (t+1).
years. The $10,000 principal will be returned in three years as well.
Modifying the duration equation we get:
ion is calculated as:

ly, duration can be represented as such:

t = how often payment is received

T = Number of periods until final maturity
= Bond principal or payment
PV= Present value calculation
To calculate the convexity of a bond portfolio, you can take a weighte
average of each component\'s convexity.
The formula illustrates how duration is affected by changes in interes
and low yields, as well as longer durations, can increase
due to time being squared.
If a portfolio manager only pays attention to
duration, the tangent line can be quite inaccurate
if a bond is heavily curved either positively or
negatively; in other words, the accuracy of
duration modeling deteriorates with greater
changes to interest rates. Portfolio managers
tend to gravitate toward bonds with greater
convexity. This is because the bond price will
theoretically increase more as interest rates fall
when compared to bonds with lower convexity.
Interest Rate Immunization Strategies
Any immunization strategy requires a
certain return over a fixed time period in order to
be successful. The aim of the strategy is to match
the duration of assets to the duration of liabilities,
with the two ultimately being offset by each other.
In the case of fixed-income instruments, such as
bonds, immunization seeks to limit changes to
the price and reinvestment risk.
Where:
t = How often payment is received
T = Number of periods until final maturity
= Difference between assets and
liabilities
= Bond principal or payment
e = Interest rate risk
PV = present value calculation
We then take another derivative in order to
expand , leaving us with:
Using this formula requires you to plug in
convexity and duration values that you calculate
based on the bonds used in the portfolio.
Immunization Strategy Drawbacks
What the immunization formula does not tell you
is what bond investments create a scenario in
which assets and liabilities offset. That's where
the complicated nature of immunization rears its
ugly head. In order to use the formula, you would
first have to find the duration and convexity of the
future liabilities, and then scour the markets for
assets that you could use to zero out. This often
requires access to some pretty sophisticated
software, as well as access to in-depth bond
market information. You would then plug in
possible assets and run scenarios until a set of
solutions presented itself.
The bottom line is that immunization involves a
complicated set of calculations. For a portfolio
comprised of government securities and high-
grade bonds, calculations might be relatively
simple, but in today's financial environment,
companies are investing in a variety of hard-to-
grasp financial instruments, such
as CDOs and junk bonds. Bonds with embedded
options tend to be more volatile, which makes
duration even more difficult to calculate. (To learn
about junk bonds, read Junk Bonds: Everything
You Need To Know.)
What Type of Investor Uses This Strategy?
Immunization strategies are frequently employed
by pension funds, institutional investors,
insurance companies and other large investors
who may have large liabilities or assets.
Businesses of this size often have millions or
billions of dollars in future liabilities, and investing
in bonds in order to protect capital puts them at
risk if interest rates increase. They can also
afford to purchase the hardware and software
required to calculate the multitude of different
scenarios in which assets and liabilities can
offset.
This sort of strategy is often too complicated or
too resource-intensive for the average investor.
The analysis of different durations, cash
flows and liabilities is complicated, and
the transaction costs associated with the
purchase and sale of derivatives can be
prohibitive.
Conclusion
Interest rates are notoriously difficult to predict,
but the consequences of downplaying the risk a
portfolio faces when it comes to shifts in interest
rates far outweigh the complexities of analysis.
Pension funds, insurance companies and
institutional investors use this hedging strategy to
reduce the likelihood of big losses.
he Effect of Fed Fund Rate
Hikes on Your Bond Portfolio
The Federal Reserve anticipates raising
the federal funds rate in either late 2015 or early
2016 after keeping record low interest rates for a
number of years in the wake of the 2008 financial
crisis. This would generally result in bond prices
sinking lower. The Fed has stated any interest
rate hike will be limited. The plan is to raise rates
gradually as the economy improves. The extent
to which a rate hike impacts a bond portfolio
depends on the portfolios duration and where
along the yield curve the portfolio is situated.
Inverse Relationship
Bonds and interest rates have an inverse
relationship. As interest rates increase, bond
prices generally fall. As interest rates fall, bond
prices go up. Bonds generally pay a stated
interest rate, also known as a coupon rate. New
bonds are issued in relation to the current
prevailing interest rates. Bond investors are
constantly looking for the best returns on their
investments.
Assume an investor owns a bond that pays a 5%
annual coupon rate. If interest rates go up to 6%,
new bonds being issued reflect these higher
rates. Investors want to own bonds with the
higher interest rate. This reduces the demand for
bonds with lower rates, including the bond only
paying 5% interest. Therefore, the price for those
bonds goes down to coincide with the lower
demand.
On the other hand, assume interest rates go
down to 4%. Bonds that pay 5% are more
attractive. Therefore, there is greater demand for
bonds with higher interest rates. As a result, bond
prices go up since there is increased demand for
the bond paying 5%.
Yield Curve
Another important consideration for a bond
portfolio is the yield curve. The yield curve refers
to a graph that plots interest rates, at a certain
time, of bonds having an equal credit quality with
different maturity rates. The most common yield
curve is based on U.S. Treasurys since the
government has never defaulted on its debt and
the credit quality is consistent across the different
maturities.
The Basics Of Bond
Duration
Rate hikes have different impacts on different
maturities of bonds. The general rule is the
longer the maturity of the bond, the greater the
Duration tells investors the length of time, in
drop in price in response to an interest rate hike.
years, that it will take a bond's cash flows to
Shorter maturity bonds are not impacted as
repay the investor the price he or she paid for the
greatly by interest rate hikes. Thus, the maturity
bond.
of the bonds an investor holds in a portfolio
determines the extent to which it is impacted by A bonds duration tells investors how much a
an interest rate hike. bond's price might change when interest rates
change i.e. how much risk they face from interest
Duration of Portfolio rate changes
The duration of the bond portfolio is another
important element to consider. Duration refers to Comparing Yield To Maturity
how long it takes for the price of a bond to be
paid by its internal cash flows. Assuming And The Coupon Rate
constant coupon rates, the longer the time to
maturity for a bond, the higher the duration. A bonds coupon rate is the amount of interest
Bonds with longer durations carry more risk. income it earns each year based on its face
Their prices are also more volatile since they value. A bonds yield to maturity is its total
have greater sensitivity to changes in interest estimated return if the bond is held until
rates. maturity. Investors base investing decisions and
strategies on yield to maturity more so than
Duration is a helpful statistic for measuring the coupon rates.
risk of a bond portfolio. It provides the effective
average maturity of the portfolio. It further Suppose a bond has a $1,000 face value and
provides an estimate of the sensitivity of the issues semi-annual interest payments of $20,
portfolio to changes in interest rates. The overall totaling $40 a year. Its coupon rate is 4%. That
duration of a portfolio can be used to help coupon is fixed. No matter what price the bond
immunize the portfolio from interest rate risk. trades for, it will pay $40 a year in interest.
More sophisticated investors may want to use
A bonds yield and its price are inversely related.
derivatives to offset this interest rate risk. The
At face value, a bonds yield and coupon rate are
easiest way to help immunize a bond portfolio
the same. But if the same bond sells at a
against interest rate risk is to adjust the duration
premium price of $1,100, its yield is 3.63%, or
of the portfolio to meet the investors time
$40 divided by $1,100.
horizon. When a bond portfolio is immunized, the
investor obtains the same rate of return no matter
Yield to maturity approximates a bonds average
what happens to interest rates.
return until it matures. It applies a single discount
rate to all future interest payments in order to
create a present value thats close to the price of
the bond. The calculation includes the coupon
rate, the price of the bond, the difference
between price and face value, and time until
maturity.
risks To
Consider Before
Investing In
Bonds
For most investors, the best investment
opportunity for them to gain practical experience
with the capital markets is fixed income. There
are many types of fixed income securities to
choose from, including sovereign debt, corporate
debt, mortgage-backed securities and asset-
backed securities, to name a few. Given the
breadth of fixed income securities that are
available to purchase, it is important for investors
to have a general understanding of their risks
before making an investment decision.
For most investors, the best investment
opportunity for them to gain practical experience
with the capital markets is fixed income. There
are many types of fixed income securities to
choose from, including sovereign debt, corporate
debt, mortgage-backed securities and asset-
backed securities, to name a few. Given the
breadth of fixed income securities that are
available to purchase, it is important for investors
to have a general understanding of their risks
before making an investment decision.
SEE: 6 Biggest Bond Risks
Types of Fixed Income Risk
In most cases, the risks associated with fixed-
income securities can be classified as default
risk, downgrade risk, credit-spread risk
and interest-rate risk. Technically speaking,
default risk is the most important type of risk that
investors should be concerned with, because a
technical default would mean that the issuer has
failed to make a periodic coupon payment over
the term of the loan, or that the issuer did not
return the principal investment to the investor
when the bond matured.
Fortunately, this type of risk is easy for most
investors to understand, although it is more
difficult for them to analyze. Downgrade risk is
also a type of risk that is relatively straightforward
to understand, because it simply represents the
potential for a reduction in the value of a bond
that would result if a credit rating agency lowered
the credit rating on the company that issued the
bond. Credit-spread risk is a little more complex
to understand, but it can be conceptualized as a
change in the price of a bond that would result if
the spread between the interest rate for the risky
bond and the interest rate for a risk-free bond
changed after the risky bond was purchased.
Fortunately, the magnitude of downgrade risk and
credit-spread risk is typically not as great as the
potential impact of default risk or interest-rate
risk. Nevertheless, investors should understand
these types of risk before investing in bonds. With
these types of risk in mind, let us now examine
one of the most talked about types of fixed
income risk, which is interest-rate risk.
Mathematical Explanation for Interest-Rate
Risk
From a mathematical standpoint, interest-rate risk
refers to the inverse relationship between the
price of a bond and market interest rates. To
explain, if an investor purchased a 5% coupon,
10-year corporate bond that is selling at par
value, the present value of the $1,000 par value
bond would be $614. This amount represents the
amount of money that is needed today to be
invested at an annual rate of 5% per year over a
10-year period, in order to have $1,000 when the
bond reaches maturity.
Now, if interest rates increase to 6%, the present
value of the bond would be $558, because it
would only take $558 invested today at an annual
rate of 6% for 10 years to accumulate $1,000. In
contrast, if interest rates decreased to 4%, the
present value of the bond would be $676. As you
can see from the difference in the present value
of these bond prices, there truly is an inverse
relationship between the price of a bond and
market interest rates, at least from a
mathematical standpoint.
SEE: Advanced Bond Concepts: Bond Pricing
Supply and Demand Explanation for Interest-
Rate Risk
From the standpoint of supply and demand, the
concept of interest-rate risk is also
straightforward to understand. For example, if an
investor purchased a 5% coupon and 10-year
corporate bond that is selling at par value, the
investor would expect to receive $50 per year,
plus the repayment of the $1,000 principal
investment when the bond reaches maturity.
Now, let's determine what would happen if market
interest rates increased by one percentage point.
Under this scenario, a newly issued bond with
similar characteristics as the originally issued
bond would pay a coupon amount of 6%,
assuming that it is offered at par value.
Therefore, under a rising interest rate
environment, the issuer of the original bond
would find it difficult to find a buyer willing to pay
par value for their bond, because a buyer could
purchase a newly issued bond in the market that
is paying a higher coupon amount. As a result,
the issuer would have to sell their bond at a
discount from par value in order to attract a
buyer. As you can probably surmise, the discount
on the price of the bond would be the amount
that would make a buyer indifferent in terms of
purchasing the original bond with a 5% coupon
amount, or the newly issued bond with a more
favorable coupon rate.
The inverse relationship between market interest
rates and bond prices holds true under a falling
interest-rate environment as well. However, now
the originally issued bond would be selling at
a premium above par value, because the coupon
payments associated with this bond would be
greater than the coupon payments offered on
newly issued bonds. As you may now be able to
infer, the relationship between the price of a bond
and market interest rates is simply explained by
the supply and demand for a bond in a changing
interest-rate environment.
The Real-World Implication of Interest-Rate
Risk
Now that we understand the relationship between
the price of a bond and market interest rates, as
typically explained by most fixed income pundits,
it is important to bring to light the third leg of the
relationship that is often ignored, forgotten, or
misunderstood. While it is true that there is an
inverse relationship between the price of a bond
and market interest rates, the issue becomes
irrelevant if the bond investor expects to hold the
security until maturity.
To explain, consider the payment stream of a
fixed rate security, which we know pays a
periodic coupon amount and the return of
principal at maturity. If interest rates change, the
bondholder still receives the same coupon
amount, and still receives the return of principal
when the bond matures. Therefore, for buy-and-
hold investors, interest-rate risk is immaterial in
nominal dollar terms.
The Bottom Line
So what are the implications of investing in fixed
income securities in a fluctuating interest-rate
environment? First, if you plan on buying a bond
and holding it until maturity, you should not worry
about interest-rate risk, but instead focus on
default risk. Second, if you plan on buying a bond
and trading it before it matures, you should buy a
bond with a higher coupon rate and shorter term-
to-maturity. The reason for this recommendation
is that a bond with these types of features will not
be as adversely affected by a rising interest rate
environment. Of course, you should keep in mind
that a bond that offers a higher coupon rate will
likely have more default risk than a bond with a
lower coupon rate. Third, you can purchase
a floating rate bond in order to minimize or
eliminate the impact of interest-rate risk.
Finally, as a bond investor, you need to determine
beforehand if your goal for buying a bond is to
generate income via periodic coupon payments,
or if you are purchasing the bond with the
expectation of receiving periodic coupon
payments, as well as a material capital gain
associated with the fluctuating price of the bond.
If periodic income is your focus, you should
concentrate on purchasing high coupon paying
bonds that have a lower probability of default risk.
If on the other hand capital gains are your
primary focus of interest, it is recommended that
you greatly enhance your knowledge of fixed
income and the global capital markets before
trying to engage in such investment strategies
Six Biggest Bond Risks
Bonds can be a great tool to generate income
and are widely considered to be a safe
investment, especially when compared to stocks.
However, investors need to be aware of some
potential pitfalls and risks to holding corporate
and/or government bonds. In this article, we'll
expose the risks that wait to steal your hard-
earned profits.
1. Interest Rate Risk
Interest rates and bond prices carry an inverse
relationship; as interest rates fall, the price of
bonds trading in the marketplace generally rises.
Conversely, when interest rates rise, the price of
bonds tends to fall. This happens because when
interest rates are on the decline, investors try to
capture or lock in the highest rates they can for
as long as they can. To do this, they will scoop up
existing bonds that pay a higher interest rate than
the prevailing market rate. This increase
in demand translates into an increase in bond
price. On the flip side, if the prevailing interest
rate were on the rise, investors would naturally
jettison bonds that pay lower interest rates. This
would force bond prices down.
Let's look at an example:

Example - Interest Rates
and Bond Price
An investor owns a bond
that trades at par
value and carries a
4% yield. Suppose the
prevailing market interest
rate surges to 5%. What
will happen? Investors will
want to sell the 4% bonds
in favor of bonds that
return 5%, which in turn
forces the 4% bonds'
price below par.
2. Reinvestment Risk
Another danger that bond investors face
is reinvestment risk, which is the risk of having to
reinvest proceeds at a lower rate than the funds
were previously earning. One of the main ways
this risk presents itself is when interest rates fall
over time and callable bonds are exercised by the
issuers.
similar bond that isn't callable. Active bond
investors can attempt to mitigate reinvestment
risk in their portfolios by staggering the
potential call dates of their differing bonds. This
limits the chance that many bonds will be called
at once.
3. Inflation Risk
When an investor buys a bond, he or she
essentially commits to receiving a rate of return,
either fixed or variable, for the duration of the
bond or at least as long as it is held.
But what happens if the cost of
living and inflation increase dramatically, and at a
faster rate than income investment? When that
happens, investors will see their purchasing
power erode and may actually achieve a negative
rate of return (again factoring in inflation).
Put another way, suppose that an investor earns
a rate of return of 3% on a bond. If inflation grows
to 4% after the bond purchase, the investor's true
rate of return (because of the decrease in
purchasing power) is -1%.

The callable feature allows the issuer to redeem

the bond prior to maturity. As a result,
the bondholder receives the principal payment,
which is often at a slight premium to the par
value.
However, the downside to a bond call is that the
investor is then left with a pile of cash that he or
she may not be able to reinvest at a comparable
rate. This reinvestment risk can have a major
adverse impact on an individual's investment
returns over time.
To compensate for this risk, investors receive a
higher yield on the bond than they would on a
4. Credit/Default Risk
When an investor purchases a bond, he or she is
actually purchasing a certificate of debt. Simply
put, this is borrowed money that must be repaid
by the company over time with interest. Many
investors don't realize that corporate bonds aren't
guaranteed by the full faith and credit of the U.S.
government, but instead depend on the
corporation's ability to repay that debt.
Investors must consider the possibility
of default and factor this risk into their investment
decision. As one means of analyzing the
possibility of default, some analysts and investors
will determine a company's coverage ratio before
initiating an investment. They will analyze the
corporation's income and cash flow statements,
determine its operating income and cash flow,
and then weigh that against its debt
service expense. The theory is the greater the
coverage (or operating income and cash flow) in
proportion to the debt service expenses, the
safer the investment.
5. Rating Downgrades
A company's ability to operate and repay its debt
(and individual debt) issues is frequently
evaluated by major ratings institutions such
as Standard & Poor's or Moody's. Ratings range
from 'AAA' for high credit quality investments to
'D' for bonds in default. The decisions made and
judgments passed by these agencies carry a lot
of weight with investors.
If a company's credit rating is low or its ability to
operate and repay is questioned, banks and
lending institutions will take notice and may
charge the company a higher interest rate for
future loans. This can have an adverse impact on
the company's ability to satisfy its debts with
current bondholders and will hurt existing
bondholders who might have been looking to
unload their positions.
6. Liquidity Risk
While there is almost always a ready market
for government bonds, corporate bonds are
sometimes entirely different animals. There is a
risk that an investor might not be able to sell his
or her corporate bonds quickly due to a thin
market with few buyers and sellers for the bond.
adverse impact on a bondholder's total
return (upon sale). Much like stocks that trade in
a thin market, you may be forced to take a much
lower price than expected to sell your position in
the bond.
Use Duration And Convexity
To Measure Bond Risk
A coupon bond makes a series of payments over
its life, so fixed-income investors need a measure
of the average maturity of the bond's promised
cash flow to serve as a summary statistic of the
effective maturity of the bond. Also needed is a
measure that could be used as a guide to
the sensitivity of a bond to interest rate changes,
since price sensitivity tends to increase with time
to maturity. The statistic that aids investors in
both areas is duration. Read on to find out how
duration and convexity can help fixed-income
investors gauge uncertainty when managing their
portfolios. (For background reading, check out
our Advanced Bond Concepts tutorial.)
Duration Defined
In 1938, Frederick Macaulay termed the effective-
maturity concept the duration of thebond, and
suggested that duration be computed as
the weighted average of the times to each
coupon or principal payment made by the
bond. Macaulay's duration formula is as follows:

Low interest in a particular bond issue can lead to

substantial price volatility and possibly have an

D is the bond's duration
C is the periodic coupon payment
F is the face value at maturity (in dollars)
T is the number of periods until maturity
r is the periodic yield to maturity
t is the period in which the coupon is
received
Duration for Portfolio Management
Duration is key in fixed-income portfolio
management for the following three reasons:
1. It is a simple summary statistic of the
effective average maturity of a portfolio.
2. It is an essential tool
in immunizing portfolios from interest rate
risk.
3. Duration is an estimate of the interest rate
sensitivity of a portfolio.
Because duration is so important to fixed-income
portfolio management, it is worth exploring the
following properties:
The duration of a zero-coupon
bond equals its time to maturity.
Holding maturity constant, a bond's
duration is lower when the coupon rate is
higher. This rule is due to the impact of
early higher coupon payments.
Holding the coupon rate constant, a
bond's duration generally increases with
time to maturity. This property of duration
is fairly intuitive; however, duration does
not always increase with time to maturity.
For some deep-discount bonds, duration
may fall with increases in maturity.
Holding other factors constant, the
duration of a coupon bond is higher when
the bond's yield to maturity is lower. This
principle applies to coupon bonds. For
zero-coupon bonds, duration equals time
to maturity, regardless of the yield to
maturity.
The duration of a level perpetuity is (1 +
y)/y. For example, at a 10% yield, the
duration of perpetuity that pays $100 once
a year forever will equal 1.10/.10 = 11
years, but at an 8% yield it will equal
1.08/.08 = 13.5 years. This principle
makes it obvious that maturity and
duration can differ substantially. The
maturity of the perpetuity is infinite,
whereas the duration of the instrument at
a 10% yield is only 11 years. The present-
value-weighted cash flow early on in the
life of the perpetuity dominates the
computation of duration. (For more
information on portfolio management,
read Equity Portfolio Management
Mechanics and Preparing For A Career
As A Portfolio Manager.)
Duration for Gap Management
Many banks have a natural mismatch between
asset and liability maturities. Bank liabilities are
primarily the deposits owed to customers, most of
which are very short-term in nature and of low
duration. Bank assets by contrast are composed
largely of outstanding commercial and consumer
loans or mortgages. These assets are of longer
duration and their values are more sensitive to
interest rate fluctuations. In periods when interest
rates increase unexpectedly, banks can suffer
serious decreases in net worth if their assets fall
in value by more than their liabilities.
To manage this risk, a technique
called gap management became popular in the
1970s and early 1980s, with the idea being to
limit the "gap" between asset and liability
durations. Adjustable-rate mortgages (ARM)
were one way to reduce the duration of bank-
asset portfolios. Unlike conventional mortgages,
ARMs do not fall in value when market rates
increase because the rates they pay are tied to
the current interest rate. Even if the indexing is
imperfect or entails lags, it greatly diminishes
sensitivity to interest rate fluctuations. On the
other side of the balance sheet, the introduction
of longer-term bank certificates of deposit (CD)
with fixed terms to maturity served to lengthen
the duration of bank liabilities, also reducing the
duration gap. (Learn more about financial gaps
in Playing The Gap.)
One way to view gap management is as an
attempt by the bank to equate the durations of
assets and liabilities to effectively immunize its
overall position from interest rate movements.
Because bank assets and liabilities are roughly
equal in size, if their durations are also equal, any
change in interest rates will affect the value of
assets and liabilities equally. Interest rate
changes would have no effect on net worth.
Therefore, net worth immunization requires a
portfolio duration, or gap, of zero. (To learn more
about bank assets and liabilities, read Analyzing
A Bank's Financial Statements.)
Institutions with future fixed obligations, such
as pension funds and insurance companies, are
different from banks in that they think more in
terms of future commitments. Pension funds, for
example, have an obligation to provide workers
with a flow of income upon retirement and must
have sufficient funds available to meet this
commitment. As interest rates fluctuate, both the
value of the assets held by the fund and the rate
at which those assets generate income fluctuate.
The portfolio manager, therefore, may want to
protect (immunize) the future accumulated
value of the fund at some target date against
interest-rate movements. The idea behind
immunization is that with duration-matched
assets and liabilities, the ability of the asset
portfolio to meet the firm's obligations should be
unaffected by interest rate movements. (Read
more about pension funds' obligations
in Analyzing Pension Risk.)
Convexity
Unfortunately, duration has limitations when used
as a measure of interest rate sensitivity. The
statistic calculates a linear relationship between
price and yield changes in bonds. In reality, the
relationship between the changes in price and
yield is convex. In Figure 1, the curved line
represents the change in prices given a change
in yields. The straight line, tangent to the curve,
represents the estimated change in price via the
duration statistic. The shaded area shows the
difference between the duration estimate and the
actual price movement. As indicated, the larger
the change in interest rates, the larger the error in
estimating the price change of the bond.

Figure 1
Convexity, which is a measure of the curvature of
the changes in the price of a bond in relation to
changes in interest rates, is used to address this
error. Basically, it measures the change in
duration as interest rates change. The formula is
as follows:
C is convexity
B is the bond price
r is the interest rate
d is duration
In general, the higher the coupon, the lower the
convexity - a 5% bond is more sensitive to
interest rate changes than a 10% bond. Because
of the call feature, callable bonds will
display negative convexity if yields fall too low,
meaning the duration will decrease when yields
decrease. (To read about some risks associated
with callable and other bonds, read Call
Features: Don't Get Caught Off
Guard and Corporate Bonds: An Introduction To
Credit Risk.)
Conclusion
Interest rates are constantly changing and add a
level of uncertainty to fixed-income investing.
Duration and convexity allow investors to quantify
this uncertainty and are useful tools in the
management of fixed-income portfolios.
How To Create A Modern
Fixed-Income Portfolio
Fixed-income investing often takes a backseat in
our thoughts to the fast-paced stock market, with
its daily action and promises of superior returns,
but if you're a retired investor, or are approaching
retirement, fixed-income investing must move into
the driver's seat. At this stage, preservation
of capital with a guaranteed income stream
becomes the most important goal.
Today, investors need to mix things up and get
exposure to different asset classes to keep
their portfolio incomes high, reduce risk and stay
ahead of inflation. Even the great Benjamin
Graham, the father of value investing, suggested
a portfolio mix of stocks and bonds for later-stage
investors. If he were alive today, he would
probably sing the same tune, especially since the
advent of new and diverse products and
strategies for income-seeking investors. In this
article, we'll lay down the road map for creating a
modern fixed-income portfolio.
SEE: Preparing To Tap Into Retirement Income
Some Historical Perspective
From the very beginning, we are taught that stock
returns outpace returns from bonds. While this
has been shown to be true, the discrepancy
between the two returns is not as great as one
might think. The Journal of American
Finance conducted a study, "Long Term
Bonds Vs. Stocks" (2004). Using more than 60
staggered 35-year intervals from 1900 to 1996,
the study showed that stock returns, after
inflation was accounted for, measured an
increase of about 5.5%. Bonds, on the other
hand, showed real returns (after inflation) of Figure 2
roughly 3%.

The Long Bond in the Rearview Mirror

One of the most important changes to fixed-
income investing in the 1990s and 2000s era is
that the long bond (a bond maturing in more than
10 years) has given up its previously substantial
yield benefit.

For example, take a look at the yield curves for

the major bond classes as they stood on Nov. 15,
2006:

Figure 3

There are several conclusions that can be

reached from a review of these charts:

The long (20- or 30-year) bond is not a

very attractive investment; in the case of
treasuries, the 30-year bond currently
yields no more than a six month Treasury
bill.

High-grade corporate bonds provide an

attractive yield pick-up to treasuries
(5.57% to 4.56% for 10-year maturities).
Figure 1
In a taxable account, municipal bonds can
offer attractive tax-equivalent yields to
 government and corporate bonds, if not
better. This involves an extra calculation to
confirm, but a good estimate is to take the
coupon yield and divide it by 0.67 to
estimate the effects of state and federal
tax savings (for a 33% tax
bracket investor).
SEE: The Basics Of Municipal Bonds
With short-term yields so close to those of long-
term yields, it simply doesn't make sense to
commit to the long bond anymore. Locking up
your money for another 20 years to gain a paltry
extra 20 or 30 basis points just doesn't pay
enough to make the investment worthwhile.
This presents an opportunity for fixed-income
investors, because purchases can be made in
the five- to 10-year maturity range, then
reinvested at prevailing rates when those bonds
come due. When these bonds mature is also a
natural time to reassess the state of the economy
and adjust your portfolio as needed.
The current relationship between short-term and
long-term yields also illustrates the utility of
a bond ladder. Laddering is investing in eight to
10 individual issues, with one coming due every
year. This can prevent you from having to
forecast interest rates into the future, as
maturities will be spread out over the yield curve,
with opportunities to readjust every year as
your visibility gets clearer.
SEE: Boost Bond Returns With Laddering
Add Spice to Your Portfolio
1. Equities
Adding some solid, high-dividend
paying equities to form a balanced portfolio is
becoming a valuable new model for late-stage
investing, even for folks well into their retirement
years. Plenty of large, established companies in
the S&P 500 pay yields in excess of current
inflation rates (which are running at about 2.5%
per year), along with the added benefit of
allowing an investor to participate in corporate
profit growth.
A simple stock screener can be used to find
companies that offer high-dividend payouts while
also meeting certain value and stability
requirements, such as those fit for a conservative
investor seeking to minimize idiosyncratic (stock-
specific) and market risks. Below is a list of
companies with the following example screen
criteria:
Size - At least $10 billion in market
capitalization
High Dividends - All pay a yield of at
least 2.8%
Low Volatility - All stocks have a beta of
less than 1, which means they have
traded with less volatility than the overall
market.
Reasonable Valuations - All stocks have
a P/E to growth ratio, or PEG ratio of 1.75
or less, which means that growth
expectations are reasonably priced into
the stock. This filter removes companies
whose dividends are artificially high due to
deteriorating earnings fundamentals.
Sector Diversification - A basket of
stocks from different sectors can minimize
certain market risks by investing in all
parts of the economy.
To be certain, investing in equities comes with
considerable risks compared with fixed income,
but these risks can be mitigated by diversifying
within sectors and keeping overall equity
exposure below 30 to 40% of the total portfolio
value.
Any myths about high-dividend stocks being
stodgy, non-performers are just that - myths.
Consider that between 1972 and 2005, stocks in
the S&P that paid dividends paid a return of over
10% per year annualized, compared with only
4.3% over the same period for stocks that did not
pay dividends. Steady amounts of cash income,
lower volatility and higher returns? They aren't
sounding so stodgy anymore, are they?
2. Real Estate
Real estate investment trusts (REITs) are another
way to get some high-yielding securities in a
conservative portfolio. They provide liquidity,
trade like stocks and have the added benefit of
being a distinct asset from bonds and equities.
REITs are a way to diversify our modern fixed-
income portfolio against market risks in stocks
and credit risks in bonds.
SEE: The REIT Way
3. High Yield Bonds
High yield bonds are another potential avenue.
The so-called "junk bonds" that offer above-
market yields are very difficult to invest in
individually with confidence, but by choosing a
fund with consistent operating results, you can
devote a portion of your portfolio to high-yield
bond issues as a way to boost fixed-income
returns.
SEE: Junk Bonds: Everything You Need To Know
Many high-yield funds will be closed-end, which
means that the price may trade higher than
the net asset value (NAV) of the fund. Look to
find a fund with little to no premium over the NAV
for an extra margin of safety when investing here.
4. Inflation-Protected Securities
Next, consider Treasury Inflation-Protected
Securities (TIPS). They are a great way to protect
against whatever inflation might throw your way in
the future. They carry a modest coupon
rate (usually between 1 and 2.5%), but the real
benefit is that the price will be adjusted
systematically to keep pace with inflation.
It is important to note that TIPS are best held in
non-taxable accounts, as the inflation
adjustments are made through additions to
the principal amount. This means that they could
create large capital gains when sold, so keep the
TIPS in that IRA, and you'll be adding some solid
inflation-fighting punch with the security that
only U.S. Treasuries can provide.
5. Emerging Market Debt
Much like with high-yield issues, emerging
market debt is best invested in a mutual fund
or exchange-traded fund (ETF). Individual issues
can be illiquid and hard to research effectively.
However, yields have historically been higher
than advanced economy debt, providing a
nice diversification that helps deter country-
specific risks. As with high-yield funds,
many emerging market funds are closed-end, so
look for ones that are reasonably priced
compared to their NAV.
A Sample Portfolio
This sample portfolio would provide valuable
exposure to other markets and asset classes.
The portfolio below (Figure 4) was created with
safety in mind. It is also poised to participate in
global growth through investments in equities
and real estate assets.

Figure 4
A Note on Risk
There are risks associated with each type of
investment listed here. Diversification among
asset classes, however, has proved to be a very
effective way to reduce overall portfolio risk. The
biggest danger to an investor seeking principal
protection with income is keeping pace with
inflation, and a savvy way to reduce this risk is by
diversifying among high quality, higher-yielding
investments more than standard bonds.
Know When to Ask for Help
If it turns out that an investor's retirement plan will
call for a periodic "drawing down" of the principal
amounts, as well as receiving the cash flows, it is
best to visit a certified financial planner (CFP).
The CFP can assist with both the investing and
accounting side of a retirement plan, since the
size of the portfolio will need to be measured
carefully to determine the optimal level of cash
flows, and maximizing tax savings will be crucial.
A CFP can also run Monte Carlo simulations to
show you how a given portfolio would react to
different economic environments, changes in
interest rates and other potential factors.
We Live in a World of Funds
There are fund options available for any
investment method described here, and deciding
whether to use one will come down to how much
time and effort an investor wishes to devote to his
or her portfolio. Choosing wisely is important
here, because fees become crucial at this level -
a fund aiming to throw off 5% per year in income
or dividends is giving up a big slice of an already
small pie with an expense ratio of even 0.5%. So
keep an eye out for funds with long track records,
low turnover and, above all else, low fees when
taking this route.
The Bottom Line
Fixed-income investing has changed dramatically
in just a short period of time. While some aspects
have become trickier, Wall Street has responded
by providing more tools for the modern fixed-
income investor to create custom portfolios.
Being a successful fixed-income investor today
just might mean going outside the classical style
boxes and using these tools to create a modern
fixed-income portfolio, one that is fit and flexible
in an uncertain world.
Common Bond-Buying
Mistakes
Individuals seeking income and/or the
preservation of capital often consider
adding bonds to their investment portfolios.
Unfortunately, most investors don't realize the
potential risks that go along with an investment in
a debt instrument. In this article, we'll take a look
at some of the more common mistakes made -
and issues overlooked - by fixed-
income investors.
Interest Rate Variability
Interest rates and bond prices have an inverse
relationship. As rates go up, bond prices decline,
and vice versa. This means that in the period
prior to a bond's redemption on its maturity date,
the price of the issue will vary widely as interest
rates fluctuate. Many investors don't realize this.
Is there a way to protect against such price
volatility?
The answer is no. The volatility is inevitable. For
this reason, fixed-income investors, regardless of
the length of the maturity of the bonds they hold,
should be prepared to maintain their positions
until the actual date of redemption. If you have to
sell the bond prior to maturity, you may end up
doing so at a loss if the interest rate has moved
against you. (For more insight, see What are the
risks of investing in a bond?)
Know The Claim Status And Features Of The
Bond
In the event of bankruptcy, bond investors have
first claim to a company's assets. In other words,
at least theoretically, they have a better chance of
being made whole if the underlying company
goes out of business.
The trouble is that not all bonds are created
equal. There are senior notes, which are often
backed by collateral (such as equipment) that are
given first claim. There are also subordinated
debentures, which still rank ahead of the
common stock in terms of claim preference, but
below that of the senior holder. It is important to
understand which you own, especially if the issue
you are buying is in any way speculative.
How can you tell what type of bond you own?
If you have the certificate in front of you, it will
likely say the words "senior note," or indicate the
bond's status in some other fashion on the
document. Alternatively, the broker that sold you
the note should be able to provide that
information, as should the underlying company's
financial documents, such as the 10-K or
the prospectus (if it is an initial issue).
One or all of these sources should be able to tell
you the following as well:
The coupon rate: the rate of interest to be
paid on the bond.
The maturity date: the date at which the
security will be redeemed.
The call provisions: the outline of options
the company may have to buy back the
debt at a later date.
The call information: this is particularly
important to know because of the
numerous pitfalls that can be associated
with this feature. For example, suppose
interest rates decline sharply after you
purchase the bond. The good news is that
the price of your holding will increase; the
bad news is that the company that issued
the debt may now be able to go into the
market, float another bond and raise
money at a lower interest rate and then
use the proceeds to buy back, or call your
bond. Typically, the company will offer you
a small premium to sell the note back to
them before maturity. But where does that
leave you? (For more on this, read Call
Features: Don't Get Caught Off Guard.)
After your bond is called, you may owe a big tax
liability on your gains, and you will probably be
forced to reinvest the money you received at the
prevailing market rate, which may have declined
since your initial investment.
Interest Coverage
Just because you own a bond or because it is
highly regarded in the investment community
doesn't guarantee that you will earn a dividend
payment, or that you will ever see the bond
redeemed. In many ways investors seem to take
this process for granted.
But rather than make the assumption that the
investment is sound, the investor should review
the company's financials and look for any reason
it won't be able to service its obligation. They
should look closely at the income statement and
then take the annual net income figure and add
back taxes, depreciation and any other non-cash
charges. This will help you to determine how
many times that figure exceeds the annual debt
service number. Ideally, there should be at least
two times coverage in order to feel comfortable
that the company will have the ability to pay down
its debt. (To learn how to read and break down
financial statements, see What You Need To
Know About Financial Statements, Get
Organized With An Investment Analysis
Form, Introduction To Fundamental
Analysis and Advanced Financial Statement
Analysis)
Market Perception
As mentioned above, bond prices can and do
fluctuate. One of the biggest sources of volatility
is the market's perception of the issue and the
issuer. If other investors don't like the issue or
think the company won't be able to meet its
obligations, or if the issuer suffers a blow to its
reputation, the price of the bond will decrease in
value. The opposite is true if Wall Street views
the issuer or the issue favorably.
A good tip for bond investors is to take a look at
the issuer's common stock to see how it is being
perceived. If it is disliked, or there is unfavorable
research in the public domain on the equity, it will
likely spill over and be reflected in the price of the
bond as well.
Issuer's History
It is important that an investor peruse old annual
reports and review a company's past
performance to determine whether it has a
history of reporting consistent earnings and has
made all interest, tax and pension plan obligation
payments in the past.
Specifically, a potential investor should read the
company's management discussion and
analysis (MD&A) section for this information. Also
read the proxy statement - it, too, will yield clues
about any problems or a company's past inability
to make payments. It may also indicate future
risks that could have an adverse impact on a
company's ability to meet its obligations or
service its debt. (To learn more about
management, see Evaluating A Company's
Management and Get Tough On Management
Puff.)
The goal of this homework is to gain some level
of comfort that the bond you are holding isn't
some type of experiment. In other words, that the
company has paid its debts in the past and,
based upon its past and expected future
earnings, that it is likely to do so in the future.
Ignoring Inflation
When bond investors hear reports
of inflation trends, they need to pay attention.
Inflation can eat away a fixed income investor's
future purchasing power quite easily. (To continue
reading about inflation, see The Importance Of
Inflation And GDP, All About Inflation and The
Forgotten Problem Of Inflation.)
For example, if inflation is growing at an annual
rate of 4%, this means that each year it will take a
4% greater return to maintain the
same purchasing power. This is important,
particularly for investors that buy bonds at or
below the rate of inflation, because they are
actually guaranteeing they'll lose money when
they purchase the security!
Of course, this is not to say that an investor
shouldn't buy a low yielding bond from a highly
rated corporation. But investors should
understand that in order to defend against
inflation, they must obtain a higher rate of return
from other investments in their portfolio such
as common stocks or high yielding bonds.
Liquidity
Financial newspapers, quote services, brokers
and a company's website may provide
information about the liquidity of the issue you
hold. More specifically, one of these sources may
yield information about what type of volume the
bond trades on a daily basis.
This is important because bondholders need to
know that if they want to dispose of their position,
adequate liquidity will ensure that there will be
buyers in the market ready to assume it.
Generally speaking, the stocks and bonds of
large, well-financed companies tend to be more
liquid than those of smaller companies. The
reason for this is simple: larger companies are
perceived as having a greater ability to repay
their debts.
Is there a certain level of liquidity that is
recommended? No. But if the issue is traded
daily in large volumes, is being quoted by the
large brokerage houses and has a fairly
narrow spread, it is probably suitable.
The Bottom Line
Contrary to popular belief, fixed income investing
involves a great deal of research and analysis.
Those who don't do their homework run the risk
of suffering low or negative returns.
Understanding
Bond Prices
and Yields
Bond prices serve as a benchmark for many
things, including interest rates, forecasts of future
economic activity and future interest rates, and
perhaps most importantly, they're a smart
component of a well managed and diversified
investment portfolio.
Understanding bond prices and yields can help
any investor in any market, including equities. In
this article we'll cover the basics of bond
prices, bond yields and how they're affected by
general economic conditions.
Bond Quotes
The chart below is taken from Bloomberg.com.
We will refer to information shown in this chart
throughout the article. Note that Treasury bills,
which mature in a year or less, are quoted
differently from bonds. T-bills are quoted at a
discount from face value, with the discount
expressed as an annual rate based on a 360-day
year. For example, you will get a
0.07*90/360=1.75% discount when you purchase
the T-bill.
Let's look at how we calculated this number. A
nd
bond's price consists of a "handle" and "32 s".
The two-year Treasury's handle is 99, and the
nd
32 s are 29. We must convert those values into
a percentage to determine the dollar amount we
will pay for the bond. To do so, we first divide 29
by 32. This equals .90625. We then add that
amount to 99 (the handle), which equals
99.90625. So, 99-29 equals 99.90625% of the
par value of $100,000, which equals
$99,906.25.Calculating
The Bond's Dollar Price
A bond's dollar price represents a percentage of
the bond's principal balance, otherwise known
as par value. In its simplest form, a bond is a
loan, and the principal balance, or par value, is
the loan amount. So, if a bond is quoted at 99-29,
and you were to buy a $100,000 two-
year Treasury bond, you would pay $99,906.25.
The two-year Treasury is trading at a discount,
which means that it is trading at less than its par
value. If it were "trading at par", its price would be
100. If it were trading at a premium, its price
would be greater than 100.
Before we discuss discount versus premium
pricing, remember that when you buy a bond, you
buy more than principal balance; you also
buy coupon payments. Different types of bonds
make coupon payments at different frequencies.
Coupon payments are made in arrears.
When you buy a bond, you are entitled to the
percentage of a coupon payment due from the
date that the trade settles until the next coupon
payment date, and the previous owner of the
bond is entitled to the percentage of that coupon
payment from last coupon payment date to the
trade settlement date.
Because you will be the holder of record when
the actual coupon payment is made and will
receive the full coupon payment, you must pay
the previous owner his or her percentage of that
coupon payment at the time of trade settlement.
In other words, the actual trade settlement
amount will consist of the purchase
price plus accrued interest.
Discount Vs. Premium Pricing
When would someone pay more than a bond's
par value? The answer is simple: when
the coupon rate on the bond is higher than
current market interest rates. In other words, the
investor will receive interest payments from a
premium priced bond that are greater than what
they could earn in the current market
environment. The same holds true for bonds
priced at a discount; they are priced at a discount
because the coupon rate on the bond is below
current market rates.
Yield Tells It All (Almost)
A yield relates a bond's dollar price to its cash
flows. A bond's cash flows consist of coupon
payments and return of principal. Principal is
usually returned at the end of a bond's term,
known as its maturity date.
A bond's yield is the discount rate that can be
used to make the present value of all of the
bond's cash flows equal to its price. In other
words, a bond's price is the sum of the present
value of each cash flow. Each cash flow is
present valued using the same discount factor.
This discount factor is the yield.
Intuitively, discount and premium pricing makes
sense. Because the coupon payments on a bond
priced at a discount are smaller than on a bond
priced at a premium, if we use the same discount
rate to price each bond, the bond with the smaller
coupon payments will have a smaller present
value (lower price).
In reality, there are several different yield
calculations for different kinds of bonds. For
example, calculating the yield on a callable
bond is difficult because the date at which the
bond might be called (the coupon payments go
away at that point) is unknown.
However, for non-callable bonds such as U.S.
Treasury bonds, the yield calculation used is
a yield to maturity. In other words, the exact
maturity date is known and the yield can be
calculated with certainty (almost). But even yield
to maturity has its flaws. A yield to maturity
calculation assumes that all the coupon
payments are reinvested at the yield to maturity
rate, although this is highly unlikely because
future rates can't be predicted.
A Bond's Yield Moves Inversely to Its Price
A bond's yield is the discount rate (or factor) that
equates the bond's cash flows to its current dollar
price. So what is the appropriate discount rate or
conversely, what is the appropriate price?
When inflation expectations rise, interest rates
rise, so the discount rate used to calculate the
bond's price increases, making the bond's price
drop. It's that simple. The opposite scenario
would be true when inflation expectations fall.
How to Determine the Appropriate Discount
Rate
We've established that inflation expectation is the
primary variable that influences the discount rate
investors use to calculate a bond's price, but
you'll notice in Figure 1 that each Treasury bond
has a different yield and that the longer the
maturity of the bond, the higher the yield. This is
because the longer a bond's term to maturity, the
greater the risk that there could be future
increases in inflation and the larger the current
discount rate that is required/used by investors to
calculate the bond's price will be. By this time,
you should recognize this higher discount rate as
being a higher yield.
The credit quality (the likelihood that a
bond's issuer will default) is also considered
when determining the appropriate discount rate
(yield); the lower the credit quality, the higher the
yield and the lower the price.
Bond Prices and the Economy
Inflation is a bond's worst enemy. When inflation
expectations rise, interest rates rise, bond yields
rise and bond prices fall. To that end, bond
prices/yields, or the prices/yields of bonds with
different maturities are an excellent predictor of
future economic activity. To see the market's
prediction of future economic activity, all you have
to do is look at the yield curve. The yield curve in
Figure 1 predicts a slight economic slow down
and slight drop in interest rates between months
six and 24. After month 24, the yield curve is
telling us that the economy should grow at a
more normal pace.
The Bottom Line
Understanding bond yields is a key to
understanding expected future economic activity
and interest rates, which is important
in everything from stock selection to deciding
when to refinance a mortgage. Use the yield
curve as an indication of potential economic
conditions to come.
Convertible
Bonds: An
Introduction
New players to the investing game often ask
what convertible bonds are, and whether they are
bonds or stocks. Essentially, they are corporate
bonds that can be converted by the holder into
the common stock of the issuing company. In this
article, we'll cover the basics of these
chameleon-like securities as well as their upsides
and downsides.
What Is a Convertible Bond?
As the name implies, convertible bonds, or
converts, give the holder the option to exchange
the bond for a predetermined number of shares
in the issuing company. When first issued, they
act just like regular corporate bonds, albeit with a
slightly lower interest rate.
Because convertibles can be changed into stock
and thus benefit from a rise in the price of
the underlying stock, companies offer
lower yields on convertibles. If the stock performs
poorly there is no conversion and an investor is
stuck with the bond's sub-par return (below what
a non-convertible corporate bond would get). As
always, there is a tradeoff between risk and
return. (For more insight, read Get Acquainted
With The Bond Price-Yield Duo.)
Conversion Ratio
The conversion ratio (also called the conversion
premium) determines how many shares can be
converted from each bond. This can be
expressed as a ratio or as the conversion price,
and is specified in the indenture along with other
provisions.
Example
A conversion ratio of 45:1 means one bond
(with a $1,000 par value) can be exchanged
for 45 shares of stock. Or it could be specified
at a 50% premium, meaning that if the investor
chooses to convert the shares, he or she will
have to pay the price of the common stock at
the time of issuance plus 50%. Basically,

these are the same thing said two different
ways.
This chart shows the performance of a
convertible bond as the stock price rises. Notice
that the price of the bond begins to rise as the
stock price approaches the conversion price. At
this point your convertible performs similarly to
a stock option. As the stock price moves up or
becomes extremely volatile, so does your bond.
It is important to remember that convertible
bonds closely follow the underlying's price. The
exception occurs when the share price goes
down substantially. In this case, at the time of the
bond's maturity, bond holders would receive no
less than the par value.
Forced Conversion
One downside of convertible bonds is that the
issuing company has the right to call the bonds.
In other words, the company has the right to
forcibly convert them. Forced conversion usually
occurs when the price of the stock is higher than
the amount it would be if the bond
were redeemed, or this may occur at the
bond's call date. This attribute caps the capital
appreciation potential of a convertible bond. The
sky is not the limit with converts as it is with
common stock. (To learn more about callable
bonds, read Bond Call Features: Don't Get
Caught Off Guard.)
The Numbers
As we mentioned earlier, convertible bonds are
rather complex securities for a few reasons. First,
they have the characteristics of both bonds and
stocks, confusing investors right off the bat. Then
you have to weigh in the factors affecting the
price of these securities; these factors are a
mixture of what is happening in the interest-rate
climate (which affects bond pricing) and the
market for the underlying stock (which affects the
price of the stock).
Then there's the fact that these bonds can be
called by the issuer at a certain price that
insulates the issuer from any dramatic spike in
share price. All of these factors are important
when pricing convertibles.
Example
Suppose that TSJ Sports issues $10 million in
three-year convertible bonds with a 5% yield
and a 25% premium. This means that TSJ will
have to pay $500,000 in interest annually, or a
total $1.5 million over the life of the converts.
If TSJ\'s stock was trading at $40 at the time
of the convertible bonds issue, investors would
have the option of converting those bonds for
shares at a price of $50 ($40 x 1.25 = $50).
Therefore if the stock was trading at say $55
by the bond\'s expiration date, that $5
difference per share is profit for the investor.
However there is usually a cap on the amount
the stock can appreciate through the issuer\'s
callable provision.
For instance, TSJ executives won\'t allow the
share price to surge to $100 without calling
their bonds - and capping investors\' profits.
Alternatively, if the stock price tanks to $25 the

convert holders would still be paid the face
value of the $1,000 bond at maturity. This
means that while convertible bonds limit risk if
the stock price plummets, they also limit
exposure to upside price movement if the
common stock soars.
Conclusion
Getting caught up in all the details and intricacies
of convertible bonds can make them appear
more complex then they really are. At their most
basic, convertibles provide a sort of security
blanket for investors wishing to participate in the
growth of a particular company they're unsure of.
By investing in converts you are limiting
your downside risk at the expense of limiting your
upside potential.
Bondas basics tutorial
5 Bond Basics: Introduction
The first thing that comes to most people's
minds when they think of investing is the
stock market. After all, stocks are exciting.
The swings in the market are scrutinized in
the newspapers and even covered by local
evening newscasts. Stories of investors
gaining great wealth in the stock market are
common.
Bonds, on the other hand, don't have the
same sex appeal. The lingo seems arcane
and confusing to the average person. Plus,
bonds are much more boring - especially
during raging bull markets, when they seem
to offer an insignificant return compared to
stocks.
However, all it takes is a bear market to
remind investors of the virtues of a bond's
safety and stability. In fact, for many investors
it makes sense to have at least part of their
portfolio invested in bonds.
This tutorial will hopefully help you determine
whether or not bonds are right for you. We'll
introduce you to the fundamentals of what
bonds are, the different types of bonds and
their important characteristics, how they
behave, how to purchase them, and more.
Read more: Bond Basics: Introduction |
Investopedia http://www.investopedia.com/uni
versity/bonds/#ixzz4ZOPikIQG
Follow us: Investopedia on Facebook
6 Bond Basics: What Are Bonds?
7 Have you ever borrowed money? Of
course you have! Whether we hit our
parents up for a few bucks to buy candy
as children or asked the bank for
a mortgage, most of us have borrowed
money at some point in our lives.
8 Just as people need money, so do
companies and governments. A company
needs funds to expand into new markets,
while governments need money for
everything from infrastructure to social
programs. The problem large
organizations run into is that they typically
need far more money than the average
bank can provide. The solution is to raise
money by issuing bonds (or other debt
instruments) to a public market.
Thousands of investors then each lend a
portion of the capital needed. Really, a
bond is nothing more than a loan for which
you are the lender. The organization that
sells a bond is known as the issuer. You (bonds) an investor becomes a creditor to
can think of a bond as an IOU given by a the corporation (or government). The
borrower (the issuer) to a lender (the primary advantage of being a creditor is
investor). that you have a higher claim on assets
than shareholders do: that is, in the case
Of course, nobody would loan his or her of bankruptcy, a bondholder will get paid
hard-earned money for nothing. The before a shareholder. However, the
issuer of a bond must pay the investor bondholder does not share in the profits if
something extra for the privilege of using a company does well - he or she is
his or her money. This "extra" comes in entitled only to the principal plus interest.
the form of interest payments, which are
made at a predetermined rate and To sum up, there is generally less risk in
schedule. The interest rate is often owning bonds than in owning stocks, but
referred to as the coupon. The date on this comes at the cost of a lower return.
which the issuer has to repay the amount
borrowed (known as face value) is called
9
the maturity date. Bonds are known
as fixed-income securities because you
Why Bother With Bonds?
know the exact amount of cash you'll get
It's an investing axiom that stocks return
back if you hold the security until maturity.
more than bonds. In the past, this has
generally been true for time periods of at
For example, say you buy a bond with a
least 10 years or more. However, this
face value of $1,000, a coupon of 8%, and
doesn't mean you shouldn't invest in
a maturity of 10 years. This means you'll
bonds. Bonds are appropriate any time
receive a total of $80 ($1,000*8%) of
you cannot tolerate the short-term volatility
interest per year for the next 10 years.
of the stock market. Take two situations
Actually, because most bonds pay interest
where this may be true:
semi-annually, you'll receive two payments
of $40 a year for 10 years. When the bond
1) Retirement - The easiest example to
matures after a decade, you'll get your
think of is an individual living off a fixed
$1,000 back.
income. A retiree simply cannot afford to
lose his/her principal as income for it is
Debt Versus Equity
required to pay the bills.
Bonds are debt, whereas stocks
are equity. This is the important distinction
2) Shorter time horizons - Say a young
between the two securities. By purchasing
executive is planning to go back for an
equity (stock) an investor becomes an
MBA in three years. It's true that the stock
owner in a corporation. Ownership comes
market provides the opportunity for higher
with voting rights and the right to share in
growth, which is why his/her retirement
any future profits. By purchasing debt
fund is mostly in stocks, but the executive
 cannot afford to take the chance of losing
the money going towards his/her
education. Because money is needed for
a specific purpose in the relatively near
future, fixed-income securities are likely
the best investment.
These two examples are clear cut, and
they don't represent all investors. Most
personal financial advisors advocate
maintaining a diversified portfolio and
changing the weightings of asset classes
throughout your life. For example, in your
20s and 30s a majority of wealth should
be in equities. In your 40s and 50s the
percentages shift out of stocks into bonds
until retirement, when a majority of your
investments should be in the form of fixed
income.
10 Bond Basics: Characteristics
11 Bonds have a number of characteristics of
which you need to be aware. All of these
factors play a role in determining the value
of a bond and the extent to which it fits in
your portfolio.
12 Face Value/Par Value
The face value (also known as the par
value or principal) is the amount of money
a holder will get back once a bond
matures. A newly issued bond usually
sells at the par value. Corporate bonds
normally have a par value of $1,000, but
this amount can be much greater for
government bonds.
What confuses many people is that the
par value is not the price of the bond. A
bond's price fluctuates throughout its life
in response to a number of variables
(more on this later). When a bond trades
at a price above the face value, it is said
to be selling at a premium. When a bond
sells below face value, it is said to be
selling at a discount.
Coupon (The Interest Rate)
The coupon is the amount the bondholder
will receive as interest payments. It's
called a "coupon" because sometimes
there are physical coupons on the bond
that you tear off and redeem for interest.
However, this was more common in the
past. Nowadays, records are more likely to
be kept electronically.
As previously mentioned, most bonds pay
interest every six months, but it's possible
for them to pay monthly, quarterly or
annually. The coupon is expressed as a
percentage of the par value. If a bond
pays a coupon of 10% and its par value is
$1,000, then it'll pay $100 of interest a
year. A rate that stays as a fixed
percentage of the par value like this is a
fixed-rate bond. Another possibility is an
adjustable interest payment, known as a
floating-rate bond. In this case the interest
rate is tied to market rates through an
index, such as the rate on Treasury bills.
You might think investors will pay more for
a high coupon than for a low coupon. All
things being equal, a lower coupon means
that the price of the bond will fluctuate
more.
Maturity
The maturity date is the date in the future
on which the investor's principal will be
 repaid. Maturities can range from as little rating. The chart below illustrates the
as one day to as long as 30 years (though different bond rating scales from the major
terms of 100 years have been issued). rating agencies in the U.S.: Moody's,
Standard and Poor's and Fitch Ratings.
A bond that matures in one year is much
more predictable and thus less riskyBond
than Rating
a bond that matures in 20 years. Grade Risk
Moody\'s S&P/ Fitch
Therefore, in general, the longer the time
to maturity, the higher the interest rate. AAA Investment Highest Qua
Also, all things being equal, a longer term
AA Investment High Quality
bond will fluctuate more than a shorter
term bond. A Investment Strong

BBB Investment Medium Gra

13
BB, B Junk Speculative
Issuer Highly
Caa/Ca/C
The issuer of a bond is a crucial factor to CCC/CC/C Junk
Speculative
consider, as the issuer's stability is your
main assurance of getting paid back. For D Junk In Default
example, the U.S. government is far more
14
secure than any corporation. Its default
Notice that if the company falls below a
risk (the chance of the debt not being paid
certain credit rating, its grade changes
back) is extremely small - so small
from investment quality to junk status.
that U.S. government securities are known
Junk bonds are aptly named: they are the
as risk-free assets. The reason behind this
debt of companies in some sort of
is that a government will always be able to
financial difficulty. Because they are so
bring in future revenue through taxation. A
risky, they have to offer much higher yields
company, on the other hand, must
than any other debt. This brings up an
continue to make profits, which is far from
important point: not all bonds are
guaranteed. This added risk means
inherently safer than stocks. Certain types
corporate bonds must offer a
of bonds can be just as risky, if not riskier,
higher yield in order to entice investors -
than stocks.
this is the risk/return tradeoff in action.
Bond Basics: Yield, Price And Other
The bond rating system helps investors Confusion
determine a company's credit risk. Think
15 Understanding the price fluctuation of
of a bond rating as the report card for a
bonds is probably the most confusing part
company's credit rating. Blue-chip firms,
of this lesson. In fact, many new investors
which are safer investments, have a high
are surprised to learn that a bond's price
rating, while risky companies have a low
 changes on a daily basis, just like that of
any other publicly-traded security. Up to
this point, we've talked about bonds as if
every investor holds them to maturity. It's
true that if you do this you're guaranteed
to get your principal back; however, a
bond does not have to be held to maturity.
At any time, a bond can be sold in the
open market, where the price can
fluctuate - sometimes dramatically. We'll
get to how price changes in a bit. First, we
need to introduce the concept of yield.
16 Measuring Return With Yield
Yield is a figure that shows the return you
get on a bond. The simplest version of
yield is calculated using the following
formula: yield = coupon amount/price.
When you buy a bond at par, yield is
equal to the interest rate. When the price
changes, so does the yield.
17 Let's demonstrate this with an example. If
you buy a bond with a 10% coupon at its
$1,000 par value, the yield is 10%
($100/$1,000). Pretty simple stuff. But if
the price goes down to $800, then the
yield goes up to 12.5%. This happens
because you are getting the same
guaranteed $100 on an asset that is worth
$800 ($100/$800). Conversely, if the bond
goes up in price to $1,200, the yield
shrinks to 8.33% ($100/$1,200).
18 Yield To Maturity
Of course, these matters are always more
complicated in real life. When bond
investors refer to yield, they are usually
referring to yield to maturity (YTM). YTM
is a more advanced yield calculation that
shows the total return you will receive if
you hold the bond to maturity. It equals all
the interest payments you will receive (and
assumes that you will reinvest the interest
payment at the same rate as the current
yield on the bond) plus any gain (if you
purchased at a discount) or loss (if you
purchased at a premium).
19 Knowing how to calculate YTM isn't
important right now. In fact, the calculation
is rather sophisticated and beyond the
scope of this tutorial. The key point here is
that YTM is more accurate and enables
you to compare bonds with different
maturities and coupons.
20 Putting It All Together: The Link
Between Price And Yield
The relationship of yield to price can be
summarized as follows: when price goes
up, yield goes down and vice versa.
Technically, you'd say the bond's price and
its yield are inversely related.
21 Here's a commonly asked question: How
can high yields and high prices both be
good when they can't happen at the same
time? The answer depends on your point
of view. If you are a bond buyer, you want
high yields. A buyer wants to pay $800 for
the $1,000 bond, which gives the bond a
high yield of 12.5%. On the other hand, if
you already own a bond, you've locked in
your interest rate, so you hope the price of
the bond goes up. This way you can cash
out by selling your bond in the future.
22 Price In The Market
So far we've discussed the factors of face
value, coupon, maturity, issuers and yield.
All of these characteristics of a bond play
 a role in its price. However, the factor that
influences a bond more than any other is
the level of prevailing interest rates in the
economy. When interest rates rise, the
prices of bonds in the market fall, thereby
raising the yield of the older bonds and
bringing them into line with newer bonds
being issued with higher coupons. When
interest rates fall, the prices of bonds in
the market rise, thereby lowering the yield
of the older bonds and bringing them into
line with newer bonds being issued with
lower coupons.
23 If you are looking for more information
about lower risk investments such as
bonds, Investopedia's Ask an Advisor
tackles the topic by answering one of our
user questions.
Bond Basics: Different Types Of
Bonds
24 Government Bonds
In general, fixed-income securities are
classified according to the length of time
before maturity. These are the three main
categories:
25 Bills - debt securities maturing in less
than one year.
Notes - debt securities maturing in one to
10 years.
Bonds - debt securities maturing in more
than 10 years.
26 Marketable securities from the U.S.
government - known collectively as
Treasuries - follow this guideline and are
issued as Treasury bonds, Treasury
notes and Treasury bills (T-bills).
Technically speaking, T-bills aren't bonds
because of their short maturity. (You can
read more about T-bills in our Money
Market tutorial.) All debt issued by Uncle
Sam is regarded as extremely safe, as is
the debt of any stable country. The debt of
many developing countries, however, does
carry substantial risk. Like companies,
countries can default on payments.
27 Municipal Bonds
Municipal bonds, known as "munis", are
the next progression in terms of risk.
Cities don't go bankrupt that often, but it
can happen. The major advantage to
munis is that the returns are free from
federal tax. Furthermore, local
governments will sometimes make their
debt non-taxable for residents, thus
making some municipal bonds completely
tax free. Because of these tax savings, the
yield on a muni is usually lower than that
of a taxable bond. Depending on your
personal situation, a muni can be a great
investment on an after-tax basis.
28 Corporate Bonds
A company can issue bonds just as it can
issue stock. Large corporations have a lot
of flexibility as to how much debt they can
issue: the limit is whatever the market will
bear. Generally, a short-term corporate
bond is less than five years; intermediate
is five to 12 years, and long term is over
12 years.
29 Corporate bonds are characterized by
higher yields because there is a higher
risk of a company defaulting than a
government. The upside is that they can
also be the most rewarding fixed-income
investments because of the risk the
 investor must take on. The company's
credit quality is very important: the higher
the quality, the lower the interest rate the
investor receives.
30 Other variations on corporate bonds
include convertible bonds, which the
holder can convert into stock, and callable
bonds, which allow the company to
redeem an issue prior to maturity.
31 Zero-Coupon Bonds
This is a type of bond that makes no
coupon payments but instead is issued at
a considerable discount to par value. For
example, let's say a zero-coupon bond
with a $1,000 par value and 10 years to
maturity is trading at $600; you'd be
paying $600 today for a bond that will be
worth $1,000 in 10 years.
32 Bond Basics: How To Read A Bond
Table
33
Column 1: Issuer - This is the company,
state (or province) or country that is issuing
the bond.
Column 2: Coupon - The coupon refers to
the fixed interest rate that the issuer pays to
the lender.
Column 3: Maturity Date - This is the date
on which the borrower will repay the investors
their principal. Typically, only the last two
digits of the year are quoted: 25 means 2025,
04 is 2004, etc.
Column 4: Bid Price - This is the price
someone is willing to pay for the bond. It is
quoted in relation to 100, no matter what the
par value is. Think of the bid price as a
percentage: a bond with a bid of 93 is trading
at 93% of its par value.
Column 5: Yield - The yield indicates annual
return until the bond matures. Usually, this is
the yield to maturity, not current yield. If
the bond is callable it will have a "c--" where
the "--" is the year the bond can be called. For
example, c10 means the bond can be called
as early as 2010.
Bond Basics: How Do I Buy Bonds?
34 Most bond transactions can be completed
through a full service or discount
brokerage. You can also open an account
with a bond broker, but be warned that
most bond brokers require a minimum
initial deposit of $5,000. If you cannot
afford this amount, we suggest looking at
a mutual fund that specializes in bonds (or
a bond fund).
35 Some financial institutions will provide
their clients with the service of transacting
government securities. However, if your
bank doesn't provide this service and you
 do not have a brokerage account, you can
purchase government bonds through a
government agency (this is true in most
countries). In the U.S. you can buy bonds
directly from the government through
TreasuryDirect
at http://www.treasurydirect.gov. The
Bureau of the Public Debt started
TreasuryDirect so that individuals could
buy bonds directly from the Treasury,
thereby bypassing a broker. All
transactions and interest payments are
done electronically.
If you do decide to purchase a bond
through your broker, he or she may tell
you that the trade is commission free.
Don't be fooled. What typically happens is
that the broker will mark up the price
slightly; this markup is really the same as
a commission. To make sure that you are
not being taken advantage of, simply look
up the latest quote for the bond and
determine whether the markup is
acceptable.
Remember, you should research bonds
just as you would stocks. We've gone over
several factors you need to consider
before loaning money to a government or
company, so do your homework!
Now you know the basics of bonds. Not
too complicated, is it? Here is a recap of
what we discussed:
Bonds are just like IOUs. Buying a bond
means you are lending out your money.
Bonds are also called fixed-income
securities because the cash flow from
them is fixed.
Stocks are equity; bonds are debt.
The key reason to purchase bonds is to
diversify your portfolio.
The issuers of bonds are governments
and corporations.
A bond is characterized by its face value,
coupon rate, maturity and issuer.
Yield is the rate of return you get on a
bond.
When price goes up, yield goes down,
and vice versa.
When interest rates rise, the price of
bonds in the market falls, and vice versa.
Bills, notes and bonds are all fixed-income
securities classified by maturity.
Government bonds are the safest bonds,
followed by municipal bonds, and then
corporate bonds.
Bonds are not risk free. It's always
possible - especially in the case of
corporate bonds - for the borrower to
default on the debt payments.
High-risk/high-yield bonds are known as
junk bonds.
You can purchase most bonds through a
brokerage or bank. If you are
a U.S. citizen, you can buy government
bonds through TreasuryDirect.
 Often, brokers will not charge a
commission to buy bonds but will mark up
the price instead.
Key Strategies
To Avoid
Negative Bond
Returns
When it comes to financial markets, investors can
be sure of three things: that markets will rise, fall
and at times remain the same. Everything else is
essentially up to chance, though investors can
employ a mix of strategies to attempt to prudently
navigate the ups and downs in the markets.
When it comes to investing in fixed
income or bond markets, portfolios can sustain
quite a bit of damage when interest rates are
rising. They can even lose if expectations are that
interest rates will increase in the future.
The Primary Risks in Bond Investing
In order to navigate the risk of negative
bond returns, investors must be cognizant of the
primary risk factors that affect bond prices. The
first is interest rate risk. Bonds fall in price when
interest rates rise, because investors are able to
invest in new bonds with similar features that pay
the higher bond coupon rates. To equalize the
market coupon rate, the existing bonds must fall
in price. Secondly, bond prices can fall because
of credit risk. If an existing bond receives
a downgrade in its credit rating, it is less
appealing to investors and they will require a
higher interest rate to invest, which, again, occurs
through a lowering of the bond price.
Credit risk can also affect liquidity risk, which is
influenced by investor supply and demand. Low
liquidity usually manifests itself through a
widening of the bid-ask spread, or a greater
difference in the quoted price between an
investor that buys a bond from one that sells.
Finally, other risks include call risk, which exists if
a company is allowed to call in a bond and issue
a new one. This almost always occurs in a period
of declining rates. Finally, there is reinvestment
risk, which takes place in a period of rising rates
when an investor must reinvest a bond that has
matured, for example.
Given the above risks, below are several
strategies of how to avoid negative bond returns.
Again, prices are at the highest risk of falling in a
rising rate environment, but certain risks also
exist during periods of falling or more stable rate
environment.
Maintain Individual Bond Positions
The simplest way to avoid losses in your bond
portfolio in a period of rising interest rates is to
buy individual bonds and hold them to maturity.
With this method, an investor is reasonably
assured to receive principal back at maturity, and
this method eliminates interest rate risk. The
current bond price may decline when rates rise,
but the investor will receive his or her original
investment back at the defined maturity date of
the bond.
Credit risk can also be eliminated, especially for
stronger credit ratings because there is minimal
risk that the underlying company
becomes insolvent and is unable to pay back its
debts. Liquidity risk is also eliminated by buying
and holding a bond until maturity, because there
is no need to trade it. In a period of declining
interest rates, the one risk that cannot be
eliminated is reinvestment risk, because the
funds received at maturity will need to be
reinvested at a lower coupon rate. However, this
is a favorable outcome in a period of rising rates.
The main alternative to investing in individual
bonds is through bond funds. In a period of rising
rates, these funds will see their positions decline
in market value. A key reason that these losses
can be permanent is many fund
managers actively buy and sell bonds, meaning
they are highly likely to sell positions at a loss
after a rise in rates, decline in credit rating or
when a lack of liquidity may mean they have to
sell at a lower market price. For these reasons,
individual bonds can definitely make more sense.
Stay Short when Rates Rise
In a rising interest rate environment, or period
where rates are projected to rise in the future,
staying invested in bonds with nearer-term
maturity dates can be important. Fundamentally,
interest rate risk is lower for bonds that have
closer maturity dates. Bond duration, which
measures the sensitivity of a bond price to
changes in interest rates, demonstrates that
prices change less for closer maturity dates. At
the shortest maturity date for money markets
funds, they adjust immediately to the higher rate
and in the vast majority of cases do not
experience any loss of principal. Overall, staying
on the shorter end of the maturity schedule can
help the bond investor avoid negative bond
returns, and provide for a pick-up in yield during a
period of rising rates.
Sell Short Your Bonds
For more adventurous investors, there are some
opportunities to short bonds. As with any
security, going short means borrowing the
security and anticipating a fall in price, after
which the investor can buy it and return what has
been borrowed. The market for shorting an
individual bond is not large or liquid, but there are
plenty of opportunities for individual investors to
invest in short bond mutual funds and exchange-
traded funds.
Other Considerations
There are, of course, many other strategies and
combinations to employ to try and avoid negative
bond returns. This includes hedging techniques,
such as using futures, options and swap spreads
to speculate on rising (or falling) rates along
certain parts of the yield curve, or on specific
bond classes or credit ratings. Inflation rates and
expectations for future inflation are also
important considerations when investing in
bonds. Inflation-adjusted bonds, such
as Treasury Inflation Protected Securities, can
help investors reduce the damage that inflation
can do on real bond returns.
As detailed above, investing in bond funds can be
tricky in a period of rising rates, but they do have
benefits in that the investor is outsourcing his or
her capital to a bond professional that should
have a fair level of expertise in specific bond
strategies in a mix of interest rate environments.
The Bottom Line
Despite the nearly infinite combination of
strategies that can be employed to speculate on
rising or falling rates as well as try and eliminate
the key risks to investing bonds identified above,
the best approach to investors may be to hold a
diversified mix of bond classes across a wide
array of maturity dates. As with any asset,
speculators will try and predict the market's
direction, but most investors would sleep better at
night by simply buying bonds at existing interest
rate levels and holding them until maturity. The
hiring of a bond professional or investing directly
in bond funds can also make sense in certain
circumstances.
It is most difficult to make money in bonds in a
rising rate environment, but there are ways to
avoid losses of principal and minimize the hit to
your current bond portfolio. At the end of the day,
higher rates are better for your portfolio as they
increase portfolio income levels, but investors
should work to make as smooth a transition as
possible to eventually benefit from the increase in
yields.
How To Choose
The Right Bond
For You
When it comes to investing, bonds are generally
the best low-risk financial instruments available.
Although they gain low interest amounts, the
majority of bonds have the advantage of being
government-backed. In times of market volatility,
the allure of bonds gains momentum because of
their dependability. Usually, investors look for
security after experiencing a precipitous
downturn in the stock market. As a result, more
investors will park their funds in securities such
as U.S. Treasuries, which gain conservative yet
stable returns. (For background reading, check
out our Bond Basics Tutorial.)
A Safe Investment
Government-backed bonds come in the form
of Treasury bills (T-bills), notes and bonds. T-bills
are short-term U.S. government securities with
maturity of a year or less. They can be bought
through a broker, a bank or directly from the
government. At maturity, the buyer of the T-bill
receives the full amount stated on the bond
certificate. The difference between the face
amount and the amount the bondholder paid for
the certificate is considered the interest gained.
This interest is exempt from state and local
income taxes, but not from federal income taxes.
Treasury notes have a longer term; they are
issued for two-, three-, five-, or 10-year periods,
and their interest rates are fixed. Treasury note
and bond owners receive interest payments
every six months. That interest must be reported
as interest income on federal tax returns. They
also come in several types, including I
bonds, Treasury inflation-protected
securities (TIPS) and U.S. government savings
bonds such as Series EE bonds. (Several factors
affect the taxable interest that must be reported;
learn more in Bond Taxation Rules.)
I Bonds
I bonds are savings bonds backed by the U.S.
government. The difference between these bonds
and the regular treasury bonds is in the interest
gained. The rate earned on these bonds is
actually a combination of two rates: a fixed
interest rate set when the investor buys the bond
and a semiannual variable rate tied to the
current inflation rate. The maximum purchase for
an I bond is $5,000 per calendar year, and the
interest stops accruing 30 years after it is issued.
Earnings from these bonds are exempt from state
and local taxes, and federal taxes can be
deferred until the bond is either redeemed or
reaches the maturity date. One key benefit here
is that if this bond is cashed to pay education
expenses, it is completely tax exempt. However, if
the bond is redeemed within the first five years,
the holder will be penalized the previous three
months' interest rate. (ILBs, such as TIPS and I-
Bonds, allow investors to curb the corrosive
effects of inflation and increase portfolio
diversification; see Hedge Your Bets With
Inflation-Linked Bonds.)
TIPS
To protect yourself against inflation, you can also
purchase the inflation indexed $1,000 bonds
known as TIPS. These bonds guarantee to beat
inflation because the principal is adjusted every
six months according to the consumer price
index, so if inflation occurs the principal amount
increases. The interest rate on these bonds never
changes and is set when the security is
purchased. The terms of these bonds are from
five to 30 years and interest is paid out to
investors every six months until maturity.
Series EE
Series EE savings bonds are different in that they
are issued at a deep discount from face value
and pay no annual interest because it
accumulates within the bond itself, and the
interest is paid out when the bond matures. The
interest income is federally taxed but exempt from
state and local taxes. If the bond is redeemed for
the purpose of funding a college education, the
interest is exempt from federal income
tax. TreasuryDirect has the most current rates on
all the bonds. (Learn more in The Lowdown On
Savings Bonds and Bond Taxation Rules.)
Corporate bonds - long-term debt issued by a
corporation - are also interest bearing.
Companies issue these bonds as a way to
increase company funds to finance major
projects. These are long-term taxable bonds that
pay the highest interest rate of all the bonds, due
to increased risk of default. The advantage for
the investor is that companies are required to pay
bondholders first, before short-term creditors, in
times of financial difficulty.
Where to Put Your Money
Moody's Bond Survey and Standard and
Poor's can also help you make a decision on
where to put your money. These rating services
grade bonds based on the credit risk of the
corporation or municipality issuing the bond. The
quality and creditworthiness of the issuing
company is displayed through these bond ratings.
A high quality bond rating of AAA from Standard
and Poor's, for example, means the bond is of
the highest investment quality, suggesting the
company will have the ability to pay both principal
and interest at maturity. On the opposite end of
the spectrum, a rating of DDD means the
corporation selling the bond is in default. These
are considered junk bonds, and the company will
most likely not be able to pay back either the
principal or interest at maturity to the bondholder.
These types of low-rated bonds are the same as
the high-yielding and speculative bonds, because
they carry the highest risk and can bring the
highest return on investment, if they are paid
back at maturity. (For more, check out How do
companies like Moody's rate bonds?)
Localizing Bonds
Local governments also issue long-term bonds in
the form of municipal bonds called "munis" - tax
free and tax-exempt bonds. These are used by
the local governments to finance public
improvements projects such as roads, bridges
and parks. Interest income from these bonds is
not subject to federal income taxes, and if you
live in the muni's issuing state, the bond's interest
income is also exempt from state and local
taxes. Capital gains on these bonds are taxable.
Although these bonds offer a lower interest rate
than corporate bonds, because of tax-exempt
advantages, munis could bring in an after-tax
return higher than a corporate bond. (Investing in
these bonds may offer a tax-free income stream
but they are not without risks; see The Basics Of
Municipal Bonds.)
You can also find and trade a variety of bonds
through the bond research web sites. When
making a decision about which bond to buy, a
good source of reference is Standard and Poor's.
In addition to bond ratings, it lists filings of
companies that issue bonds. Investors can use
this information when searching for the most
financially stable corporations.
The Bottom Line
Like stocks, investing in corporate bonds requires
informed decisions. Finding out the ratings and
reading the financial statements of companies
will lead to a more confident choice. If you decide
on Treasury securities, make sure you are
comfortable with the return and term of your
investment decision. Especially in times of high
levels of stock market insecurity, it is wise to build
a stronger and more stable portfolio with a variety
of bonds. (Learn the basic terms to breakdown
this seemingly complex investment area;
read The ABCs Of The Bond Market.)
Find The Right Bond At
The Right Time
percentage of every investment portfolio should
be allocated to bonds at some point over an
investor's lifetime. This is because bonds provide
stable and relatively safe cash flows (income),
which is vital for an investor who is in the asset
drawdown or capital preservation stage of their
investment planning, and for investors nearing
that stage. In its most simple terms, if you
depend on income from your investments to pay
the bills and your daily living expenses (or will in
the near future), you should be investing in
bonds. In this article we'll discuss several
different types of bonds, and identify how each
might be used to meet an investor's objectives.
SEE: Advantages Of Bonds
Building Your Portfolio
Unlike an investment in stocks, a portfolio of
bonds can be structured to meet an investor's
exact income needs because with stocks, the
investor might be dependent on uncertain and
unpredictable capital gains to pay the bills.
Additionally, if an investor is liquidating stocks for
current income, they might have to do so at
precisely the wrong time - when the volatile stock
market is down.
A well-structured bond portfolio doesn't have this
problem. Income can be derived from coupon
payments, or a combination of coupon payments
and the return of principal at a bond's maturity.
Any income that is not needed at a bond's
maturity is strategically reinvested in another
bond for future needs - this way income
bond is non-callable
requirements are met, while the maximum
(meaning the principle
amount of capital is preserved. The bottom line is
cannot be bought out
that bonds provide a historically less volatile less
early) and has the same
risky, and more predictable source of income
maturity date as the
than stocks.
Treasury bond, we can
interpret the extra 2% in
Different Bonds, Different Maturities
yield to be a measure of
There are U.S. Treasury bonds, corporate
credit risk. This measure
bonds, mortgage bonds, high-yield bonds,
of credit risk, or spread,
municipal bonds, foreign bonds, and emerging
will change according to
market bonds - just to name a few. Each type
company specific and
comes in different maturities (from long-term to
market conditions.
short-term). Let's take a look at a few of these
bonds closer up.
If you're wiling to give up some yield in exchange
for a risk-free portfolio, you can use Treasury
U.S. Treasury Bonds
bonds to structure a portfolio with coupon
U.S. Treasury bonds are considered one of the
payments and maturities that match your income
safest, if not the safest, investments in the world.
needs. The key is to minimize your reinvestment
For all intents and purposes, they are considered
risk by matching those coupon payments and
to be risk-free. (Note: They are free of credit risk,
maturities as closely as possible to your income
but not interest rate risk.)
needs. You can even buy U.S. Treasuries directly
U.S. Treasury bonds are frequently used as a from the U.S. Treasury Department at the same
benchmark for other bond prices or yields. Any prices (yields) as large financial firms at Treasury
bond's price is best understood by also looking at Direct.
its yield. As a measure of relative value, the
Corporate Bonds
yields of most bonds are quoted as a yield
While not all publicly traded companies raise
spread to a comparable U.S. Treasury bond.
money through issuing bonds, there are
corporate bonds from thousands of different
Example - Yield Spreads
issuers available. Corporate bonds have credit
The spread on a certain
risk, and therefore must be analyzed based on
corporate bond might be
the company's business prospects and cash flow.
200 basis points above the
Business prospects and cash flow are different -
current 10-year Treasury.
a company might have a bright future, but might
This means the corporate
not have the current cash flow to meet its debt
bond is yielding 2% more
obligations. Credit rating agencies such as
than the current 10-year
Moody's and Standard & Poor's provide ratings
Treasury. Therefore, if we
on corporate bonds to help an investor assess
assume that this corporate
the issuer's ability to make timely interest and
principal payments.
Yield provides a useful measure of relative value
between corporate bonds and with respect to
U.S. Treasuries. When comparing two or more
corporate bonds based on yield, it is important to
recognize the importance of maturity.
Example - Bond Yield
and Credit Risk
A five-year corporate bond
with a yield of 7% might
not have the same credit
risk as a 10-year corporate
bond with the same yield
of 7%. If the five-year U.S.
Treasury is yielding 4%,
and the 10-year U.S.
Treasury is yielding 6%,
we might conclude that
the 10-year corporate
bond has less credit risk
because it is trading at a
"tighter" spread to its
Treasury benchmark. In
general, the longer the
maturity of a bond, the
higher the yield that is
required by investors. The
bottom line is, don\'t try to
make relative value
comparisons based on
yields between bonds with
different maturities without
recognizing those
differences. And, watch
out for and recognize any
call features (or other
option features) that
corporate bonds might
have, as they will also
affect the yield.
Diversification is key to minimizing risk while
maximizing return in a stock portfolio - it's equally
important in a corporate bond portfolio. Corporate
bonds can be purchased through a retail broker
with the minimum face value generally worth
$1,000 (but it can often be higher).
Mortgage Bonds
Mortgage Bonds are similar to corporate bonds in
that they carry some credit risk, and therefore
trade at a yield spread to U.S. Treasuries.
Mortgage bonds also
have prepayment and extension risk - types of
interest rate risks associated with the probability
that the underlying borrowers will refinance their
mortgages as prevailing interest rates change. In
other words, mortgage bonds have an embedded
call option that can be exercised by the borrower
at any time. The valuation of this call option
greatly affects the yields of mortgage-based
securities. This must be well understood by any
investor making relative value comparisons
between mortgage bonds and/or other types of
bonds.
There are three general types of mortgage
bonds: Ginnie Mae, agency and private label
bonds.
Ginnie Mae bonds are backed by the full
faith and credit of the U.S. Government -
the loans backing Ginnie Mae bonds are
guaranteed by the Federal Housing
Administration (FHA), Veterans Affairs, or
other federal housing agencies.
 Agency mortgage bonds are those issued
by the home financing government
sponsored enterprises (GSEs): Fannie
Mae, Freddie Mac and the Federal Home
Loan Banks. While these bonds don't
carry the full faith and credit of the U.S.
Government, they are guaranteed by the
GSE's, and the market generally believes
that these firms have an implicit guarantee
of backing by the federal government.
Private label bonds are issued by financial
institutions such as large mortgage
originators or Wall Street firms.
Ginnie Mae bonds carry no credit risk (similar to
U.S. Treasuries), agency mortgage bonds carry
some credit risk and private label mortgage
bonds can carry a great deal of credit risk.
Mortgage bonds can be an important part of a
diversified bond portfolio, but the investor must
understand their unique risks. Credit rating
agencies can provide guidance in assessing
credit risks, but beware - the rating agencies
sometimes get it wrong. Mortgage bonds can be
bought and sold through a retail broker.
High-Yield Bonds, Muni Bonds, Other Bonds
In addition to the Treasury, corporate and
mortgage bonds described above, there are
many other bonds that can be used strategically
in a well-diversified, income-generating portfolio.
Analyzing the yield of these bonds relative to U.S.
Treasuries and relative to comparable bonds of
the same type and maturity is key to
understanding their risks.
Just as with price movements in stocks, bonds
yields are not consistent from one sector to
another. For example, the yields of high-yield
bonds versus emerging market bonds might
change as political risks in developing countries
change. You can effectively use yield
comparisons between bonds and sectors to
make a relative value analysis only when you
understand where those differences in yields
come from. Make sure you understand how the
maturity of a bond affects its yield - this includes
embedded call options or prepayment options
which can change the maturity. (Find out more
about these bonds in High Yield, Or Just High
Risk?)
Conclusion
Bonds have a place in every long-term
investment strategy. Don't let your life's savings
vanish in stock market volatility. If you depend on
your investments for income or will in the near
future, you should be invested in bonds. When
investing in bonds, make relative value
comparisons based on yield, but make sure you
understand how a bond's maturity and features
affect its yield. Most importantly, study and
understand relevant benchmark rates like the 10-
year Treasury to put each potential investment
into its proper prospective.
Corporate Bonds: Advantages and
Disadvantages
Investors considering fixed-income securities
might want to research corporate bonds, which
some have described as the last safe investment.
As the yields of many fixed-income securities
declined after the financial crisis, the interest
rates paid by corporate bonds made them more
appealing. Corporate bonds have their own
unique advantages and disadvantages.
Strong Returns
One major draw of corporate bonds is their
strong returns. Yields on some government
bonds have repeatedly plunged to new record
lows. The U.S. government sold $12 billion worth
of 30-year Treasury bonds for a 2.172% yield on
July 13, 2016, breaking the previous record of
2.43% set in January 2015. The yields on
German 10-year bonds also ventured into record-
low territory, selling with a yield of negative
0.05%.
In contrast to these record lows, corporate bonds
representing high-quality companies and
maturing in seven to 10 years paid
3.14% yields on July 14, 2016. One year earlier,
these securities were paying a yield of 3.92%.
Liquidity
Many corporate bonds trade in the secondary
market, which permits investors to buy and sell
these securities after they have been issued. By
doing so, investors can potentially benefit from
selling bonds that have risen in price, or buying
bonds after a price decline.
Some corporate bonds are thinly traded. Market
participants looking to sell these securities should
also know that numerous variables could affect
their transactions, including interest rates, the
credit rating of their bonds and the size of their
position.
Widespread Options
There are many types of corporate bonds, such
as short-term bonds with maturities of five years
or less, medium-term bonds that mature in five to
12 years and long-term bonds that mature in
more than 12 years.
Beyond maturity considerations, corporate bonds
may offer many different coupon structures.
Bonds that have a zero-coupon rate do not make
any interest payments. Instead, governments,
government agencies and companies issue
bonds with zero-coupon rates at a discount to
their par value. Bonds with a fixed coupon rate
pay the same interest rate until they reach
maturity, usually on an annual or semiannual
basis.
The interest rates for bonds with floating coupon
rates are based on a benchmark, such as the
Consumer Price Index (CPI) or the London
Interbank Offered Rate (LIBOR), adding a certain
number of basis points (bps) to the benchmark.
The interest payments change along with the
benchmark.
A step coupon rate provides interest payments
that change at predetermined times, and usually
increase. Most of these securities come with
a call provision, meaning that investors receive
the initial interest rate until the call date. After
reaching the call date, the issuer either calls the
bond or hikes the interest rate.
Risks
One major risk of corporate bonds is credit risk. If
the issuer goes out of business, the investor may
not receive interest payments or get his or her
principal back. This contrasts with bonds that
have been issued by a government with a high
credit rating, as this entity could theoretically
increase taxes to make payments to
bondholders.
Another notable risk is event risk. Companies
could face unforeseen circumstances that could
undermine their ability to generate cash flow. The
interest payments or repayment of principal
associated with a bond depend on an issuer's
ability to generate this cash flow. Corporate
bonds can provide a reliable stream of income for
investors. These debt-based securities became
particularly attractive after the financial crisis, as
central bank stimulus helped push the yields on
many fixed-income securities lower. Interested
investors can choose from many different kinds of
corporate bonds, and these securities frequently
enjoy substantial liquidity. However, corporate
bonds also have their own unique drawbacks.
5 Fixed Income Plays After the Fed
Rate Increase
Rising interest rates can cause problems for fixed
income investors. One of the basic concepts of
bond investing is the inverse relationship that
exists between interest rates and bond prices. As
interest rates rise, bond prices normally fall.
Rates mean that the prices of existing bonds
offering lower rates must drop to attract buyers.
For example, if an investor buys a $5,000 bond
with a coupon rate of 5%, but the interest rate
offered on the same type of bond rises to 6%,
bond buyers will be unwilling to pay the $5,000
original price for those 5% bonds when they can
now invest the same amount of money and
receive 6% interest. To make the 5% bonds
marketable, they must be offered for sale at a
discounted price. Investors who already hold the
5% bonds are looking at their investments losing
value.
The extent to which rising rates impact specific
bonds varies according to the type and maturity
of the bonds. Bonds with shorter terms to
maturity are generally less affected, since
investors will receive their principal back sooner
with the opportunity to reinvest at higher rates.
Lower-quality bonds that already carry higher
yields will also be less affected. The strategies
that investors can employ to manage their fixed
income investments in a rising rate environment
commonly depend on the term to maturity or the
yield/risk relationship.
1) Professional Portfolio
Management
Bondholders who typically choose and make their
own individual bond investments may wish to
move more toward investing in professionally
managed bond mutual funds or exchange-traded
funds (ETFs). Professional bond portfolio
managers can often make better or timelier
adjustments to the changing rate environment
than an individual investor operating on his own
might manage.
2) Shorter Maturities
Investors can adjust their bond holdings to bonds
of shorter duration. Shorter-term bonds are less
susceptible to negative value impacts from rising
rates, since interest rates do not generally
change significantly over the short term. Bonds
with shorter durations afford investors the
opportunity to cash in their bonds and reinvest
within a shorter span of time, when negative
effects from rising rates should be minimal. As
rates do gradually rise, investors can regularly
reinvest in new bonds offered at higher interest
rates.
3) High-Yield Bonds
Because high-yield bonds already offer yields
above the average available interest rates, they
are less affected by changes in interest rates. Of
course, higher yield generally always means
higher risk, so investors have to consider the
creditworthiness of the issuer and balance the
competing forces of risk and reward when
choosing bonds. Opting for high-yield bonds can
be a very helpful strategy in a rising rate
environment, but investors should not violate their
own personal risk tolerance levels.
4) Bonds That Perform Best in
Rising Rate Environments
Investors can shift their fixed income portfolio
assets to certain types of bonds that tend to fare
better than average when interest rates are rising.
Among the bonds that typically do the best for
investors in terms of minimizing risk and
generating the best total returns during times of
rising rates are Treasury inflation-protected
securities (TIPS), premium bonds, and short or
ultrashort bond funds. Short bond funds are
designed to profit from falling bond prices.
5) Floating Rate Bonds or Bond
Funds
Another alternative strategy to use in a rising rate
environment is to invest in floating rate bonds or
bond funds. The interest rates for floating rate
bonds are periodically adjusted, typically
somewhere between every 30 to 90 days, in
accord with an interest rate benchmark such as
the prime rate or LIBOR. These types of bonds
often offer somewhat higher yields with minimal
additional risk.
Investors must always consider the total picture
when making fixed income investments. Beyond
simply taking into account Interest rates and
available yields, the ultimate focus is a bond's
total return on investment (ROI), which includes
the interest earned over the time period that the
bond is held and any capital gains or losses
resulting from any price change in the bond that
has occurred between the purchase date and the
date when the bond is sold.
Muni Bonds vs.
Bond Funds:
Better
Together?
A lot of people say that death and taxes are the
only guarantees in life, but you can certainly add
change to that list. And when it comes to
investing, too many people tend to look at a
situation as black or white. As is the case with
most things in life, in order to be successful, its
important to have maneuverability.
Investing in bonds adds a bit of stability to one's
investment portfolio, especially during bear
markets when stocks are volatile and their returns
are depreciating. But if you invest only in an
individual municipal bond a debt security
issued by a state, city or county with a set-it-
and-forget-it approach, then you would be lacking
diversification and putting your money at risk.
Despite municipal bonds having a very low
default rate on a historical basis, even the
highest-rated municipal bond has the potential to
default. (For related reading, see: Diversify With
Municipal Bond ETFs.)
A potentially smarter solution to investing in
munis is to spread your capital out across various
individual municipal bonds. This requires a great
deal of research and tracking of your
investments, which means a lot of invested time
in addition to lots of capital. Another option is to
complement investments in municipal bonds with
investments in bond funds funds invested
primarily in bonds and other debt instruments
which spreads your risk out a bit while allowing
you to keep a steady income stream. (For more,
see: How Does Duration Impact Bond Funds?)
Lets dig a little deeper.
Municipal Bonds
Municipal bonds are attractive because of their
safety. The chart below on default rate
comparisons tells the story:
Individual Municipal Municipal bond,
Year/Bond Type
Bonds High-Yieldinterest
2011 0.23% 1.52%
2012 0.14% 1.00%
2013 0.11% 0.81%
2014 0.17% 1.26%
(Source: McGraw Hill Financial)
Despite default rates climbing in 2014, theyre still
exceptionally low, especially for individual
municipal bonds. Income investors like municipal
bonds for their safety, but also for the specific
payout amounts on a bi-annual basis. The
investors principal will also be returned when the
bond matures. (For related reading, see: How Is
a Corporate Bond Taxed?)
The biggest risk with municipal bonds is default,
but you can limit this risk by checking the
municipal bonds credit worthiness. Also, if you
see a high yield on a municipal bond, it means
higher risk. An added tip is that general obligation
bonds are safer than revenue bonds because an
issuer is relying on taxes to pay the bond holder,
and taxes can always be raised. With revenue
bonds, the issuer is relying on the performance
toll road, airport, hospital, etc. (For related
reading, see: How Are Zero-Coupon Municipal
Bonds Taxed?)
If youre willing to invest more time and money,
you can diversify your portfolio of individual
municipal bonds to manage interest rate risk. You
can also sell an individual municipal bond before
it matures, but this could lead to a profit or a loss.
This will depend on the price you paid for the
Bondsthe interest youve collected, current
Marketrates, and the current price of the bond.
A negative here is that individual municipal bonds
arent very liquid.
Investing in just one individual municipal bond
would present high risk. Therefore, a lot of time
and capital would be required to spread out your
risk across a variety of individual municipal
bonds. If you want to allocate a lot of capital in
one place while mitigating your risk and not
having to do a lot of research, then your first
considerations should be treasury bonds. (For
related reading, see: Is a Treasury Bond a Good
Investment for Retirement?)
Bond Funds
The biggest advantage to investing in bond funds
is diversification. A bond fund, or bond mutual
fund, acts similar to a stock mutual fund, where
diversification is the primary focus. Risk is spread
out across many different types of investments
and the fund is managed by a professional.
Instead of diversifying across sectors and
industries or across small-caps, mid-caps, and
large-caps like a stock mutual fund a bond
mutual fund diversifies across short-term bonds,
medium-term bonds, long-term bonds, U.S.
government agencies, corporations, and more.
(For more, see: Bond Basics: Introduction.)
You can also find focused bond mutual funds,
which is set up similarly to a focused stock
mutual fund. For example, in a focused stock
mutual fund, the focus might be on small caps
spread across different sectors and industries. In
the case of a focused bond mutual fund, the
focus might be on short-term
treasuries, investment-grade bonds or junk
bonds. (For more, see: Pros and Cons of Bond
Funds vs. Bond ETFs.)
Bond funds in general pay monthly, but not on
the same day every month. The monthly
payments are possible because of the mix of
distribution dates for the bonds within the fund.
This is also why the distribution date changes.
If you sell a bond mutual fund, you will receive
the NAV minus a redemption fee (in some
cases). Bond funds rarely hold bonds to maturity,
which makes them more liquid. You can also
invest in a bond fund ETF. If you take this
approach, consider Vanguard since it has very
low fees. (For related reading, see: Vanguard to
Launch Muni Bond ETF.)
When you invest in a bond mutual fund, check
the annual expense ratio and if theres a
transaction fee with the purchase. Do some
comparison shopping to make sure youre getting
the best deal. (For more, see: Bond Basics:
Yield, Price and Other Confusion.)
Default risk is much lower when you invest in a
bond mutual fund, simply because the risk is
spread out. If one bond defaults, its not going to
have a disastrous impact on your portfolio. If
youre the type of investor who wants a steady
income stream without having to stay on top of
your investments, then you might want to be
more heavily weighted toward bond funds than
individual municipal bonds. However, savvy
investors will often mix in a little of both, along
with stocks, CDs, real estate, and possibly
currencies and commodities, depending on
current market conditions.
The Bottom Line
You manage individual municipal bonds. That
being the case, if you limit your investments to
one or just a few, you face higher risk. If you want
diversification, then more time and capital will be
required. Individual municipal bonds have
historically offered very low risk and reliable
interest payments, which are usually bi-annual
(not to mention a tax advantage). For the lowest
risk, consider general obligation bonds opposed
to revenue bonds. However, both types of
individual municipal bonds lack liquidity. Adding
bond funds or bond mutual funds to your portfolio
offers diversification, which limits default risk.
Bond funds are more liquid and payments are
usually monthly. They are a better option for
investors who dont have as much time or money
available. That said, individual municipal bonds
and bond funds can complement each other well.
Preferred Stocks versus
Bonds: How to Choose
What are the similarities and differences
between bonds and preferred stocks, two (out of
many) methods by which a company may
raise capital?
A preferred stock is generally considered
between to a bond and common stock in the
sense that it pays fixed dividends like a bond but
takes lower precedence than a bond in case
of liquidation proceedings.
Similarities
Interest rate sensitivity
Both bonds and preferred stocks prices fall when
interest rates rise because the future cash
flows are discounted at a higher rate and offer a
better dividend yield. The opposite is true when
interest rates fall.
Callability
Both securities may have an embedded call
option (making them "callable") that gives the
issuer the right to call back the security in case of
a fall in interest rates and issue fresh securities at
a lower rate. This not only caps the investors
upside potential but also poses the problem
of reinvestment risk. (For more, see: Callable
Bonds: Leading A Double Life.)
Voting rights
Neither security offers the holder voting rights in
the company.
Capital appreciation
There is very limited scope for capital
appreciation for these instruments as they have a
fixed payment that does not benefit them from the
firms future growth.
Convertibility
This option allows investors to convert either
security into a fixed number of shares of the
common stock of the company, which allows
them to participate in the firms future growth.
Differences
Seniority
As discussed above, both bonds and preferred
stocks are senior to common stock, but bonds
take precedence over preferred stocks
in bankruptcy proceedings. Whereas interest
payments on bonds are legal obligations and are
payable before tax payments, dividends on
preferred stocks are after-tax payments and are
not made if the company is facing financial
difficulties. Any missed dividend payment may or
may not be payable in the future depending on
whether the security is cumulative or non-
cumulative.
Risk
Generally, preferred stocks are rated two notches
below bonds with regards to risk to account for
the lower claim on assets of the company.
Yield
Preferred stocks have a higher yield than bonds
to compensate for the higher risk.
Par value
Preferred stocks generally have a lower par
value than bonds, thereby requiring a lower
investment. Both are usually issued at par.
Bonds or Preferred Stocks?
Institutional investors like preferred stocks due to
the preferential tax treatment the dividends
receive. This may suppress yields, which is a
negative for individual investors.
The very fact that companies are raising capital
through preferred stocks could signal that the
company is loaded with debt, which may also
pose legal limitations on the amount of additional
debt it can raise. Companies in the financial
and utilities sectors mostly issue preferred
stocks, leading to a lack of diversification.
The Bottom Line
The high yield of preferred stocks is definitely a
positive, and in todays low interest rate
environment they can definitely add value to a
portfolio. Adequate research needs to be done
about the financial position of the company,
however, or investors may suffer losses.
Another option is to invest in a mutual fund that
invests in preferred stocks of various companies.
This gives the dual benefit of a high dividend
yield and risk diversification.
How To Compare Yields On Different
Bonds
Calculating and comparing bond yields isn't easy.
Bonds can have varying frequencies
of coupon payments; the number of days in the
year may also differ. Because fixed-income
investments use a variety of yield conventions, it
is important to convert the yield to a common
basis when comparing different bonds. Taken
separately, these conversions are
straightforward; however, when a problem
contains both compounding period and day
count conversions, the correct solution technique
is not so obvious. In this article, we'll take a look
at a couple of the common problems investors
run into when calculating these yields and show
you how to work them out. (To learn all about
bonds, see our Bond Basics and Advanced Bond
Concepts tutorials.)
Current Conventions
U.S. Treasury bills (T-bills) and
corporate commercial paper are quoted and
traded in the market on a discount basis. This
means that there is no explicit coupon interest
payment - the difference between the face
value at maturity and the current price is the
implicit interest payment. The amount of the
discount is stated as a percentage of the face
value, which is then annualized over a 360-day
year. (Keep reading about commercial paper
in Money Market: Commercial Paper and Asset-
Backed Commercial Paper Carries High Risk.)
The problems with rates quoted on a discount
basis are well-known: first, a discount rate is a
downwardly biased representation of the
investor's rate of return (or the borrower's cost of
funds) over the term to maturity; and, second, the
rate is based on a hypothetical year that has only
360 days. The downward bias comes from stating
the discount as a percentage of the face value.
In investment analysis, one naturally thinks of a
rate of return as the interest earned divided by
the current price, not the face value. Since the
price of a T-bill is less than its face value, the
denominator is too high, so the discount rate
understates the true yield.
Bank CDs have historically been quoted on a
360-day year also, and institutionally, many still
are. However, because the rate is a little higher
using a 365-day year, most retail CDs are now
quoted using a 365-day year. Returns are
marketed using annual percentage yield or APY.
This rate is not to be confused with APR
or annual percentage rate, the rate at which most
banks quote mortgages. In an APR calculation,
the interest rate received during the period is
simply multiplied by the number of periods in a
year. The effect of compounding is not included.
APY, however, takes effects of compounding into
account. (To learn more, read APR Vs. APY:
How The Distinction Affects You.)
A six-month CD that pays 3% interest has an
APR of 6%. However, the APY is 6.09%,
calculated as follows:
APY = (1 + 0.03)^2 1 =
6.09%
Yields on Treasury notes and bonds, corporate
bonds and municipal bonds are quoted on
a semiannual bond basis (SABB) because their
coupon payments are made semiannually.
Compounding is twice a year, and a 365-day year
is used.
Conversions
365 Days Vs. 360 Days
In order to properly compare the yields on
different fixed-income investments, it is important
to use the same yield calculation. The first and
easiest conversion is changing a 360-day yield to
a 365-day yield. To change the rate, simply
"gross up" the 360 day yield by the factor
365/360. A 360-day yield of 8% would equate to
a 8.11% yield based on a 365-day year.
8% x (365/360) = 8.11%
Discount Rates - 182 Days
Discount rates, commonly used on T-bills, are
generally converted to a bond-equivalent
yield (BEY), sometimes called a coupon-
equivalent or an investment yield. The conversion
formula for "short-dated" bills with a maturity of
182 or fewer days is the following:
Where:
BEY = the bond-equivalent yield
DR = the discount rate (expressed as a decimal)
N = the number of days between settlement and
maturity
Long Dates
For "long-dated" T-bills that have a maturity of
more than 182 days, the usual conversion
formula is a little more complicated because of
compounding. The formula is:
Short Dates
For short-dated T-bills, the
implicit compounding period for the BEY is the
number of days between settlement and maturity.
However, the BEY for a long-dated T-bill does not
have any well-defined compounding assumption
which makes its interpretation rather difficult.
BEYs are systematically less than the annualized
yields for semi-annual compounding. In general,
for the same current and future cash flows, more
frequent compounding at a lower rate
corresponds to less frequent compounding at a
higher rate. A yield for more frequent than
semiannual compounding - such as is implicitly
assumed with both short-dated and long-dated
BEY conversions - must be lower than the
corresponding yield for actual semiannual
compounding.
BEYs and the Treasury
BEYs reported by the Federal Reserve and
other financial market institutions should not be
used as a comparison to the yields on longer
maturity bonds. The problem is not that the
widely used BEYs are inaccurate, they just serve
a different purpose. That purpose is to facilitate
comparison of yields on T-bills, T-notes and T-
bonds maturing on the same date. To make an
accurate comparison, discount rates should be
converted to a semiannual bond basis (SABB),
because that is the basis commonly used for
longer maturity bonds.
To calculate SABB, the same formula to calculate
APY is used. The only difference is that
compounding happens twice a year. Therefore,
APYs using a 365-day year can be directly
compared to yields based on SABB.
A discount rate (DR) on an N-day T-bill can be
converted directly to a SABB with the following
formula:
A convenient feature in this equation is that it is
stated as a function only of N and DR, which are
directly observable for any traded T-bill. It is not
necessary to calculate the price of the bill,
making the equation a little easier to program into
a spreadsheet and avoiding
unnecessary rounding errors. Another key
feature is that this conversion formula applies to
both short-dated and long-dated T-bills. Unlike
BEYs, the SABB presents the yields in a form
fully comparable to the yields on Treasury notes
and bonds. The formula converts the T-bill
discount rate, quoted for a 360-day year and
360/N compounding periods per year, to a more
reasonable investment yield, quoted for a 365-
day year and two compounding periods.
Conclusion
In summary, comparison of alternative fixed-
income investments always requires conversion
of yields to a common basis. The general rule is
that the effects of compounding should be
included and conversions should always be done
on a 365-day bond basis. Comparing bond yields
may not be easy, but it shouldn't be too difficult
for the average investor either.
Advanced Bond
Concepts
Advanced Bond Concepts: Introduction
In their simplest form, bonds are pretty
straightforward. After all, just about anyone can
comprehend the borrowing and lending of money.
However, like many securities, trading and
analyzing bonds involves some more complicated
underlying concepts.
The goal of this tutorial is to explain the more
complex aspects of fixed-income securities. We'll
reinforce and review bond fundamentals such as
pricing and yield, explore the term structure of
interest rates, and delve into the topics
of duration and convexity. (Note: Although
technically a bond is a fixed-income security with
a maturity of ten years or more, in this tutorial we
use the terms "bond" and "fixed-income security"
interchangeably.)
The information and explanations in this tutorial
assume that you have a basic understanding of
fixed-income securities.
Advanced Bond Concepts: Bond Type
Specifics
Before getting to the all-important subject of bond
pricing, we must first understand the many
different characteristics bonds can have.
When it comes down to it, a bond is simply a
contract between a lender and a borrower by
which the borrower promises to repay a loan
with interest. However, bonds can take on many
additional features and/or options that can
complicate the way in which prices and yields are
calculated. The classification of a bond depends
on its type of issuer, priority, coupon
rate and redemption features. The following chart
outlines these categories of bond characteristics:
1) Bond Issuers
As the major determiner of a bond's credit quality,
the issuer is one of the most important
characteristics of a bond. There are significant
differences between bonds issued by
corporations and those issued by a state
government/municipality or national government.
In general, securities issued by the federal
government have the lowest risk of default while
corporate bonds are considered to be riskier
ventures. Of course there are always exceptions
to the rule. In rare instances, a very large and
stable company could have a bond rating that is
better than that of a municipality. It is important
for us to point out, however, that like corporate
bonds, government bonds carry various levels of
risk; because all national governments are
different, so are the bonds they issue.
International bonds (government or corporate)
are complicated by different currencies. That is,
these types of bonds are issued within a market
that is foreign to the issuer's home market, but
some international bonds are issued in the
currency of the foreign market and others are
denominated in another currency. Here are some
types of international bonds:
The definition of the eurobond market can
be confusing because of its name.
Although the euro is the currency used by
participating European Union countries,
eurobonds refer neither to the European
currency nor to a European bond market.
A eurobond instead refers to any bond
that is denominated in a currency other
than that of the country in which it is
issued. Bonds in the eurobond market are
categorized according to the currency in
which they are denominated. As an
example, a eurobond denominated in
Japanese yen but issued in the U.S.
would be classified as a euroyen bond.
Foreign bonds are denominated in the
currency of the country in which a foreign
entity issues the bond. An example of
such a bond is the samurai bond, which is
a yen-denominated bond issued in Japan
by an American company. Other popular
foreign bonds include bulldog and yankee
bonds.
Global bonds are structured so that they
can be offered in both foreign and
eurobond markets. Essentially, global
bonds are similar to eurobonds but can be
offered within the country whose currency
is used to denominate the bond. As an
example, a global bond denominated in
yen could be sold to Japan or any other
country throughout the Eurobond market.
2) Priority
In addition to the credit quality of the issuer, the
priority of the bond is a determiner of the
probability that the issuer will pay you back your
money. The priority indicates your place in line
should the company default on payments. If you
hold an unsubordinated (senior) security and the
company defaults, you will be first in line to
receive payment from the liquidation of its assets.
On the other hand, if you own
a subordinated (junior) debt security, you will get
paid out only after the senior debt holders have
received their share.
3) Coupon Rate
Bond issuers may choose from a variety of types
of coupons, or interest payments.
Straight, plain vanilla or fixed-rate bonds
pay an absolute coupon rate over a
specified period of time. Upon maturity,
the last coupon payment is made along
with the par value of the bond.
Floating rate debt instruments
or floaters pay a coupon rate that varies
according to the movement of the
underlying benchmark. These types of
coupons could, however, be set to be a
fixed percentage above, below, or equal to
the benchmark itself. Floaters typically
follow benchmarks such as the three, six
or nine-month T-bill rate or LIBOR.
Inverse floaters pay a variable coupon rate
that changes in direction opposite to that
of short-term interest rates. An inverse
floater subtracts the benchmark from a set
coupon rate. For example, an inverse
floater that uses LIBOR as the underlying
benchmark might pay a coupon rate of a
certain percentage, say 6%, minus
LIBOR.
Zero coupon, or accrual bonds do not pay
a coupon. Instead, these types of bonds
 are issued at a deep discount and pay the
full face value at maturity.
4) Redemption Features
Both investors and issuers are exposed
to interest rate risk because they are locked into
either receiving or paying a set coupon rate over
a specified period of time. For this reason, some
bonds offer additional benefits to investors or
more flexibility for issuers:
Callable, or a redeemable bond features
gives a bond issuer the right, but not the
obligation, to redeem his issue of bonds
before the bond's maturity. The issuer,
however, must pay the bond holders
a premium. There are two subcategories
of these types of bonds: American callable
bonds and European callable bonds.
American callable bonds can be called by
the issuer any time after the call
protection period while European callable
bonds can be called by the issuer only on
pre-specified dates.
The optimal time for issuers to call their
bonds is when the prevailing interest rate
is lower than the coupon rate they are
paying on the bonds. After calling its
bonds, the company could refinance its
debt by reissuing bonds at a lower coupon
rate.
Convertible bonds give bondholders the
right but not the obligation to convert their
bonds into a predetermined number of
shares at predetermined dates prior to the
bond's maturity. Of course, this only
applies to corporate bonds.
Puttable bonds give bondholders the right
but not the obligation to sell their bonds
back to the issuer at a predetermined
price and date. These bonds generally
protect investors from interest rate risk. If
prevailing bond prices are lower than the
exercise par of the bond, resulting from
interest rates being higher than the bond's
coupon rate, it is optimal for investors to
sell their bonds back to the issuer and
reinvest their money at a higher interest
rate.
Unlimited Types of Bonds
All of the characteristics and features described
above can be applied to a bond in practically
unlimited combinations. For example, you could
theoretically have a Malaysian corporation issue
a subordinated yankee bond paying a floating
coupon rate of LIBOR + 1% that is callable at the
choice of the issuer on certain dates of the year.
Read more: Advanced Bond Concepts: Bond
Type Specifics |
Investopedia http://www.investopedia.com/univer
sity/advancedbond/advancedbond1.asp#ixzz4ZO
SbNh2p
Follow us: Investopedia on Facebook
Advanced Bond Concepts: Bond Pricing
It is important for prospective bond buyers to
know how to determine the price of a bond
because it will indicate the yield received should
the bond be purchased. In this section, we will
run through some bond price calculations for
various types of bond instruments.
Bonds can be priced at a premium, discount, or
at par. If the bond's price is higher than its par
value, it will sell at a premium because its interest
rate is higher than current prevailing rates. If the C = coupon payment
bond's price is lower than its par value, the bond n = number of payments
will sell at a discount because its interest rate is i = interest rate, or required yield
lower than current prevailing interest rates. When M = value at maturity, or par value
you calculate the price of a bond, you are
calculating the maximum price you would want to
pay for the bond, given the bond's coupon rate in
The succession of coupon payments to be received in
comparison to the average rate most investors
the future is referred to as an ordinary annuity, which
are currently receiving in the bond market.
is a series of fixed payments at set intervals over a
Required yield or required rate of return is the
fixed period of time. (Coupons on a straight bond are
interest rate that a security needs to offer in order
paid at ordinary annuity.) The first payment of an
to encourage investors to purchase it. Usually the
ordinary annuity occurs one interval from the time at
required yield on a bond is equal to or greater
which the debt security is acquired. The calculation
than the current prevailing interest rates.
assumes this time is the present.

Fundamentally, however, the price of a bond is

You may have guessed that the bond pricing formula
the sum of the present values of all
shown above may be tedious to calculate, as it
expected coupon payments plus the present
requires adding the present value of each future
value of the par value at maturity. Calculating
coupon payment. Because these payments are paid at
bond price is simple: all we are doing is
an ordinary annuity, however, we can use the shorter
discounting the known future cash flows.
PV-of-ordinary-annuity formula that is mathematically
Remember that to calculate present value (PV) -
equivalent to the summation of all the PVs of future
which is based on the assumption that each
cash flows. This PV-of-ordinary-annuity formula
payment is re-invested at some interest rate once
replaces the need to add all the present values of the
it is received--we have to know the interest rate
future coupon. The following diagram illustrates how
that would earn us a known future value. For
present value is calculated for an ordinary annuity:
bond pricing, this interest rate is the required
yield. (If the concepts of present and future value
are new to you or you are unfamiliar with the
calculations, refer to Understanding the Time
Value of Money.)

Here is the formula for calculating a bond's price,

which uses the basic present value (PV) formula:

Each full moneybag on the top right represents the
fixed coupon payments (future value) received in
periods one, two and three. Notice how the present
value decreases for those coupon payments that are
further into the future the present value of the second
coupon payment is worth less than the first coupon
and the third coupon is worth the lowest amount today.
The farther into the future a payment is to be received,
the less it is worth today - is the fundamental concept
for which the PV-of-ordinary-annuity formula accounts.
It calculates the sum of the present values of all future
cash flows, but unlike the bond-pricing formula we saw
earlier, it doesn't require that we add the value of each
coupon payment.
By incorporating the annuity model into the bond
pricing formula, which requires us to also include the
present value of the par value received at maturity, we
arrive at the following formula:
Let's go through a basic example to find the price
of a plain vanilla bond.
Example 1: Calculate the price of a bond with a
par value of $1,000 to be paid in ten years, a
coupon rate of 10%, and a required yield of 12%.
In our example we'll assume that coupon
payments are made semi-annually to bond
holders and that the next coupon payment is
expected in six months. Here are the steps we
have to take to calculate the price:
1. Determine the Number of Coupon
Payments: Because two coupon payments will
be made each year for ten years, we will have a
total of 20 coupon payments.
2. Determine the Value of Each Coupon
Payment: Because the coupon payments are
semi-annual, divide the coupon rate in half. The
coupon rate is the percentage off the bond's par
value. As a result, each semi-annual coupon
payment will be $50 ($1,000 X 0.05).
3. Determine the Semi-Annual Yield: Like the
coupon rate, the required yield of 12% must be
divided by two because the number of periods
used in the calculation has doubled. If we left the
required yield at 12%, our bond price would be
very low and inaccurate. Therefore, the required
semi-annual yield is 6% (0.12/2).
4. Plug the Amounts Into the Formula:

From the above calculation, we have determined
that the bond is selling at a discount; the bond
price is less than its par value because the
required yield of the bond is greater than the
coupon rate. The bond must sell at a discount to
attract investors, who could find higher interest
elsewhere in the prevailing rates. In other words,
because investors can make a larger return in the
market, they need an extra incentive to invest in
the bonds.
Accounting for Different Payment
Frequencies
In the example above coupons were paid semi-
annually, so we divided the interest rate and
coupon payments in half to represent the two
payments per year. You may be now wondering
whether there is a formula that does not require
steps two and three outlined above, which are
required if the coupon payments occur more than
once a year. A simple modification of the above
formula will allow you to adjust interest rates and
coupon payments to calculate a bond price for
any payment frequency:
Notice that the only modification to the original
formula is the addition of "F", which represents
the frequency of coupon payments, or the
number of times a year the coupon is paid.
Therefore, for bonds paying annual coupons, F
would have a value of one. Should a bond pay
quarterly payments, F would equal four, and if the
bond paid semi-annual coupons, F would be
two.
Pricing Zero-Coupon Bonds
So what happens when there are no coupon
payments? For the aptly-named zero-coupon
bond, there is no coupon payment until maturity.
Because of this, the present value of annuity
formula is unnecessary. You simply calculate the
present value of the par value at maturity. Here's
a simple example:
Example 2(a): Let's look at how to calculate the
price of a zero-coupon bond that is maturing in
five years, has a par value of $1,000 and a
required yield of 6%.
1. Determine the Number of Periods: Unless
otherwise indicated, the required yield of most
zero-coupon bonds is based on a semi-annual
coupon payment. This is because the interest on
a zero-coupon bond is equal to the difference
between the purchase price and maturity value,
but we need a way to compare a zero-coupon
bond to a coupon bond, so the 6% required yield
must be adjusted to the equivalent of its semi-
annual coupon rate. Therefore, the number of
periods for zero-coupon bonds will be doubled,
so the zero coupon bond maturing in five years
would have ten periods (5 x 2).
2. Determine the Yield: The required yield of 6%
must also be divided by two because the number
of periods used in the calculation has doubled.
The yield for this bond is 3% (6% / 2).
3. Plug the amounts into the formula:
You should note that zero-coupon bonds are
always priced at a discount: if zero-coupon bonds
were sold at par, investors would have no way of
making money from them and therefore no
incentive to buy them.
Pricing Bonds between Payment Periods
Up to this point we have assumed that we are
purchasing bonds whose next coupon payment
occurs one payment period away, according to
the regular payment-frequency pattern. So far, if
we were to price a bond that pays semi-annual
coupons and we purchased the bond today, our
calculations would assume that we would receive
the next coupon payment in exactly six months.
Of course, because you won't always be buying a
bond on its coupon payment date, it's important
you know how to calculate price if, say, a semi-
annual bond is paying its next coupon in three
months, one month, or 21 days.
Determining Day Count
To price a bond between payment periods, we
must use the appropriate day-count convention.
Day count is a way of measuring the appropriate
interest rate for a specific period of time. There is
actual/actual day count, which is used mainly for
Treasury securities. This method counts the exact
number of days until the next payment. For
example, if you purchased a semi-
annual Treasury bond on March 1, 2003, and its
next coupon payment is in four months (July 1,
2003), the next coupon payment would be in 122
days:
Time Period = Days Counted
March 1-31 = 31 days
April 1-30 = 30 days
May 1-31 = 31 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 122 days
To determine the day count, we must also know
the number of days in the six-month period of the
regular payment cycle. In these six months there
are exactly 182 days, so the day count of the
Treasury bond would be 122/182, which means
that out of the 182 days in the six-month period,
the bond still has 122 days before the next
coupon payment. In other words, 60 days of the
payment period (182 - 122) have already passed.
If the bondholder sold the bond today, he or she
must be compensated for the interest accrued on
the bond over these 60 days.
(Note that if it is a leap year, the total number of
days in a year is 366 rather than 365.)
For municipal and corporate bonds, you would
use the 30/360 day count convention, which is
much simpler as there is no need to remember
the actual number of days in each year and
month. This count convention assumes that a
year consists of 360 days and each month
consists of 30 days. As an example, assume the
above Treasury bond was actually a semi-annual
corporate bond. In this case, the next coupon
payment would be in 120 days.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 120 days
As a result, the day count convention would be
120/180, which means that 66.7% of the coupon
period remains. Notice that we end up with
almost the same answer as the actual/actual day
count convention above: both day-count
conventions tell us that 60 days have passed into
the payment period.
Determining Interest Accrued
Accrued interest is the fraction of the coupon
payment that the bond seller earns for holding
the bond for a period of time between bond
payments. The bond price's inclusion of any
interest accrued since the last payment period
determines whether the bond's price is "dirty" or
"clean." Dirty bond prices include any accrued
interest that has accumulated since the last
coupon payment while clean bond prices do not.
In newspapers, the bond prices quoted are often
clean prices.
However, because many of the bonds traded in
the secondary market are often traded in
between coupon payment dates, the bond seller
must be compensated for the portion of the
coupon payment he or she earns for holding the
bond since the last payment. The amount of the
coupon payment that the buyer should receive is
the coupon payment minus accrued interest. The
following example will make this concept more
clear.
Example 3: On March 1, 2003, Francesca is
selling a corporate bond with a face value of
$1,000 and a 7% coupon paid semi-annually. The
next coupon payment after March 1, 2003, is
expected on June 30, 2003. What is the interest
accrued on the bond?
1. Determine the Semi-Annual Coupon
Payment: Because the coupon payments are
semi-annual, divide the coupon rate in half, which
gives a rate of 3.5% (7% / 2). Each semi-annual
coupon payment will then be $35 ($1,000 X
0.035).
2. Determine the Number of Days Remaining
in the Coupon Period: Because it is a corporate
bond, we will use the 30/360 day-count
convention.
Time Period = Days Counted
March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days
There are 120 days remaining before the next
coupon payment, but because the coupons are
paid semi-annually (two times a year), the regular
payment period if the bond is 180 days, which,
according to the 30/360 day count, is equal to six
months. The seller, therefore, has accumulated
60 days worth of interest (180-120).
3. Calculate the Accrued Interest: Accrued
interest is the fraction of the coupon payment that
the original holder (in this case Francesca) has
earned. It is calculated by the following formula:
In this example, the interest accrued by
Francesca is $11.67. If the buyer only paid her
the clean price, she would not receive the $11.67
to which she is entitled for holding the bond for
those 60 days of the 180-day coupon period.
Now you know how to calculate the price of a
bond, regardless of when its next coupon will be
paid. Bond price quotes are typically the clean
prices, but buyers of bonds pay the dirty, or full
price. As a result, both buyers and sellers should
understand the amount for which a bond should
be sold or purchased. In addition, the tools you
learned in this section will better enable you to
learn the relationship between coupon rate,
required yield and price as well as the reasons
for which bond prices change in the market.
Advanced Bond Concepts: Yield and Bond
Price
In the last section of this tutorial, we touched on
the concept of required yield. In this section we'll
explain what this means and take a closer look
into how various yields are calculated.
The general definition of yield is the return an
investor will receive by holding a bond to maturity.
So if you want to know what your bond
investment will earn, you should know how to
calculate yield. Required yield, on the other hand,
is the yield or return a bond must offer in order for
it to be worthwhile for the investor. The required
yield of a bond is usually the yield offered by
other plain vanilla bonds that are currently offered
in the market and have similar credit
quality and maturity.
Once an investor has decided on the required
yield, he or she must calculate the yield of a bond
he or she wants to buy. Let's proceed and
examine these calculations.
Calculating Current Yield
A simple yield calculation that is often used to
calculate the yield on both bonds and the
dividend yield for stocks is the current yield. The
current yield calculates the percentage return that
the annual coupon payment provides the investor.
In other words, this yield calculates what
percentage the actual dollar coupon payment is
of the price the investor pays for the bond. The
multiplication by 100 in the formulas below
converts the decimal into a percentage, allowing
us to see the percentage return:
So, if you purchased a bond with a par value of
$100 for $95.92 and it paid a coupon rate of 5%,
this is how you'd calculate its current yield:
Notice how this calculation does not include
any capital gains or losses the investor would
make if the bond were bought at a discount or
premium. Because the comparison of the bond
price to its par value is a factor that affects the
actual current yield, the above formula would give
a slightly inaccurate answer - unless of course
the investor pays par value for the bond. To
correct this, investors can modify the current yield
formula by adding the result of the current yield to
the gain or loss the price gives the investor: [(Par
Value Bond Price)/Years to Maturity]. The
modified current yield formula then takes into
account the discount or premium at which the
investor bought the bond. This is the full
calculation:
Let's re-calculate the yield of the bond in our first
example, which matures in 30 months and has a
coupon payment of $5:
The adjusted current yield of 6.84% is higher
than the current yield of 5.21% because the
bond's discounted price ($95.92 instead of
$100) gives the investor more of a gain on the
investment.
One thing to note, however, is whether you
buy the bond between coupon payments. If
you do, remember to use the dirty price in
place of the market price in the above
equation. The dirty price is what you will
actually pay for the bond, but usually the
figure quoted in U.S. markets is the clean
price.
Now we must also account for other factors
such as the coupon payment for a zero-
coupon bond, which has only one coupon
payment. For such a bond, the yield
calculation would be as follows:
n = years left until maturity
If we were considering a zero-coupon bond that
has a future value of $1,000 that matures in two
years and can be currently purchased for $925,
we would calculate its current yield with the
following formula:
Calculating Yield to Maturity
The current yield calculation we learned
above shows us the return the annual coupon
payment gives the investor, but this
percentage does not take into account
the time value of money or, more specifically,
the present value of the coupon payments the
investor will receive in the future. For this
reason, when investors and analysts refer to
yield, they are most often referring to the yield
to maturity (YTM), which is the interest rate by
which the present values of all the future cash
flows are equal to the bond's price.
An easy way to think of YTM is to consider it
the resulting interest rate the investor receives
if he or she invests all of his or her cash flows
(coupons payments) at a constant interest
rate until the bond matures. YTM is the return
the investor will receive from his or her entire
investment. It is the return that an investor
gains by receiving the present values of the
coupon payments, the par value and capital
gains in relation to the price that is paid.
This is due to the fact that a bond's price will be
The yield to maturity, however, is an interest higher when it pays a coupon that is higher than
rate that must be calculated through trial and prevailing interest rates. As market interest rates
error. Such a method of valuation is increase, bond prices decrease.
complicated and can be time consuming, so
investors (whether professional or private) will The second concept we need to review is the
typically use a financial calculator or program basic price-yield properties of bonds:
that is quickly able to run through the process
of trial and error. If you don't have such a
Premium bond: Coupon rate is greater
program, you can use an approximation
than market interest rates.
method that does not require any serious
Discount bond: Coupon rate is less than
mathematics.
market interest rates.

To demonstrate this method, we first need to
review the relationship between a bond's price
and its yield. In general, as a bond's price
increases, yield decreases. This relationship
is measured using the price value of a basis
point (PVBP). By taking into account factors
such as the bond's coupon rate and credit
rating, the PVBP measures the degree to
which a bond's price will change when there is
a 0.01% change in interest rates.
Thirdly, remember to think of YTM as the yield a
bondholder receives if he or she reinvested all
coupons received at a constant interest rate,
which is the interest rate that we are solving for. If
we were to add the present values of all future
cash flows, we would end up with the market
value or purchase price of the bond.
The calculation can be presented as:

The charted relationship between bond price

and required yield appears as a negative
curve:
 number of bond prices by plugging various
annual interest rates that are higher than 5% into
the above formula. Here is a table of the bond
prices that result from a few different interest
Example 1: You hold a bond whose par value is
rates:
$100 but has a current yield of 5.21% because
the bond is priced at $95.92. The bond matures
in 30 months and pays a semi-annual coupon of
5%.

1. Determine the Cash Flows: Every six

months you would receive a coupon payment of
$2.50 (0.025*100). In total, you would receive
five payments of $2.50, plus the future value of
$100.
2. Plug the Known Amounts into the YTM
Formula:
Remember that we are trying to find the semi-
annual interest rate, as the bond pays the coupon
semi-annually.
Because our bond price is $95.92, our list shows
that the interest rate we are solving for is
between 6%, which gives a price of $95, and 7%,
which gives a price of $98. Now that we have
found a range between which the interest rate
lies, we can make another table showing the
prices that result from a series of interest rates
that go up in increments of 0.1% instead of 1.0%.
Below we see the bond prices that result from
various interest rates that are between 6.0% and
7.0%:

3. Guess and Check: Now for the tough part:

solving for "i," or the interest rate. Rather than
pick random numbers, we can start by
considering the relationship between bond price
and yield. When a bond is priced at par, the
interest rate is equal to the coupon rate. If the
bond is priced above par (at a premium), the
coupon rate is greater than the interest rate. In We see then that the present value of our bond
our case, the bond is priced at a discount from (the price) is equal to $95.92 when we have an
par, so the annual interest rate we are seeking interest rate of 6.8%. If at this point we did not
(like the current yield) must be greater than the find that 6.8% gives us the exact price that we
coupon rate of 5%. are paying for the bond, we would have to make
another table that shows the interest rates in
Now that we know this, we can calculate a 0.01% increments. You can see why investors
prefer to use special programs to narrow down
the interest rates - the calculations required to
find YTM can be quite numerous!
Calculating Yield for Callable and Puttable
Bonds
Bonds with callable or puttable redemption
features have additional yield calculations.
A callable bond's valuations must account for the
issuer's ability to call the bond on the call date
and the puttable bond's valuation must include
the buyer's ability to sell the bond at the pre-
specified put date. The yield for callable bonds is
referred to as yield-to-call, and the yield for
puttable bonds is referred to as yield-to-put.
Yield to call (YTC) is the interest rate that
investors would receive if they held the bond until
the call date. The period until the first call is
referred to as the call protection period. Yield to
call is the rate that would make the bond's
present value equal to the full price of the bond.
Essentially, its calculation requires two simple
modifications to the yield-to-maturity formula:
Note that European callable bonds can have
multiple call dates and that a yield to call can be
calculated for each.
Yield to put (YTP) is the interest rate that
investors would receive if they held the bond until
its put date. To calculate yield to put, the same
modified equation for yield to call is used except
the bond put price replaces the bond call value
and the time until put date replaces the time until
call date.
For both callable and puttable bonds, astute
investors will compute both yield and all yield-to-
call/yield-to-put figures for a particular bond, and
then use these figures to estimate the expected
yield. The lowest yield calculated is known
as yield to worst, which is commonly used by
conservative investors when calculating their
expected yield. Unfortunately, these yield figures
do not account for bonds that are not redeemed
or are sold prior to the call or put date.
Now you know that the yield you receive from
holding a bond will differ from its coupon rate
because of fluctuations in bond price and from
the reinvestment of coupon payments. In
addition, you are now able to differentiate
between current yield and yield to maturity. In our
next section we will take a closer look at yield to
maturity and how the YTMs for bonds are
graphed to form the term structure of interest
rates, or yield curve.
Advanced Bond Concepts: Term Structure
of Interest Rates
The term structure of interest rates, also known
as the yield curve, is a very common bond
valuation method. Constructed by graphing the
yield to maturities and the respective maturity
dates of benchmark fixed-income securities, the
yield curve is a measure of the market's
expectations of future interest rates given the
current market conditions. Treasuries, issued by
the federal government, are considered risk-free,
and as such, their yields are often used as the
benchmarks for fixed-income securities with the
same maturities. The term structure of interest
rates is graphed as though each coupon payment
of a noncallable fixed-income security were a
zero-coupon bond that "matures" on the coupon
payment date. The exact shape of the curve can
be different at any point in time. So if the normal
yield curve changes shape, it tells investors that
they may need to change their outlook on the
economy.
There are three main patterns created by the
term structure of interest rates:
1) Normal Yield Curve: As its name indicates,
this is the yield curve shape that forms during
normal market conditions, wherein investors
generally believe that there will be no significant
changes in the economy, such as in inflation
rates, and that the economy will continue to grow
at a normal rate. During such conditions,
investors expect higher yields for fixed income
instruments with long-term maturities that occur
farther into the future. In other words, the market
expects long-term fixed income securities to offer
higher yields than short-term fixed income
securities. This is a normal expectation of the
market because short-term instruments generally
hold less risk than long-term instruments; the
farther into the future the bond's maturity, the
more time and, therefore, uncertainty the
bondholder faces before being paid back
the principal. To invest in one instrument for a
longer period of time, an investor needs to be
compensated for undertaking the additional risk.
Remember that as general current interest rates
increase, the price of a bond will decrease and its
yield will increase.
2) Flat Yield Curve: These curves indicate
that the market environment is sending mixed
signals to investors, who are interpreting
interest rate movements in various ways.
During such an environment, it is difficult for
the market to determine whether interest rates
will move significantly in either direction farther
into the future. A flat yield curve usually occurs
when the market is making a transition that
emits different but simultaneous indications of
what interest rates will do. In other words, there
may be some signals that short-term interest
rates will rise and other signals that long-term
interest rates will fall. This condition will create
a curve that is flatter than its normal positive
slope. When the yield curve is flat, investors
can maximize their risk/return tradeoff by
choosing fixed-income securities with the
least risk, or highest credit quality. In the rare
instances wherein long-term interest rates
decline, a flat curve can sometimes lead to an
inverted curve.
 The Theoretical Spot Rate Curve
3) Inverted Yield Curve: These yield curves are
Unfortunately, the basic yield curve does not
rare, and they form during extraordinary market
account for securities that have varying coupon
conditions wherein the expectations of investors
rates. When the yield to maturity was calculated,
are completely the inverse of those demonstrated
we assumed that the coupons were reinvested at
by the normal yield curve. In such abnormal
an interest rate equal to the coupon rate,
market environments, bonds with maturity dates
therefore, the bond was priced at par as though
further into the future are expected to offer lower
prevailing interest rates were equal to the bond's
yields than bonds with shorter maturities. The
coupon rate.
inverted yield curve indicates that the market
currently expects interest rates to decline as time
The spot-rate curve addresses this assumption
moves farther into the future, which in turn means
and accounts for the fact that many Treasuries
the market expects yields of long-term bonds to
offer varying coupons and would therefore not
decline. Remember, also, that as interest rates
accurately represent similar noncallable fixed-
decrease, bond prices increase and yields
income securities. If for instance you compared a
decline.
10-year bond paying a 7% coupon with a 10-
year Treasury bond that currently has a coupon
You may be wondering why investors would
of 4%, your comparison wouldn't mean much.
choose to purchase long-term fixed-income
Both of the bonds have the same term to
investments when there is an inverted yield
maturity, but the 4% coupon of the Treasury bond
curve, which indicates that investors expect to
would not be an appropriate benchmark for the
receive less compensation for taking on more
bond paying 7%. The spot-rate curve, however,
risk. Some investors, however, interpret an
offers a more accurate measure as it adjusts the
inverted curve as an indication that the economy
yield curve so it reflects any variations in the
will soon experience a slowdown, which causes
interest rate of the plotted benchmark. The
future interest rates to give even lower yields.
interest rate taken from the plot is known as the
Before a slowdown, it is better to lock money into
spot rate.
long-term investments at present prevailing
yields, because future yields will be even lower.

The spot-rate curve is created by plotting the
yields of zero-coupon Treasury bills and their
corresponding maturities. The spot rate given by
each zero-coupon security and the spot-rate
curve are used together for determining the value
of each zero-coupon component of a noncallable
fixed-income security. Remember, in this case,
that the term structure of interest rates is graphed
as though each coupon payment of a noncallable
fixed-income security were a zero-coupon bond.
T-bills are issued by the government, but they do
not have maturities greater than one year. As a
result, the bootstrapping method is used to fill in
interest rates for zero-coupon securities greater
than one year. Bootstrapping is a complicated
and involved process and will not be detailed in
this section (to your relief!); however, it is
important to remember that the bootstrapping
method equates a T-bill's value to the value of all
zero-coupon components that form the security.
The Credit Spread
The credit spread, or quality spread, is the
additional yield an investor receives for acquiring
a corporate bond instead of a similar federal
instrument. As illustrated in the graph below, the
spread is demonstrated as the yield curve of the
corporate bond and is plotted with the term
structure of interest rates. Remember that the
term structure of interest rates is a gauge of the
direction of interest rates and the general state of
the economy. Corporate fixed-income securities
have more risk of default than federal securities
and, as a result, the prices of corporate securities
are usually lower, while corporate bonds usually
have a higher yield.
When inflation rates are increasing (or the
economy is contracting) the credit spread
between corporate and Treasury securities
widens. This is because investors must be
offered additional compensation (in the form of a
higher coupon rate) for acquiring the higher risk
associated with corporate bonds.
When interest rates are declining (or the
economy is expanding), the credit spread
between Federal and corporate fixed-income
securities generally narrows. The lower interest
rates give companies an opportunity to borrow
money at lower rates, which allows them to
expand their operations and also their cash flows.
When interest rates are declining, the economy is
expanding in the long run, so the risk associated
with investing in a long-term corporate bond is
also generally lower.
Let's first work through some visual models that
Now you have a general understanding of the demonstrate the properties of duration for a zero-
concepts and uses of the yield curve. The yield coupon bond and a vanilla bond.
curve is graphed using government securities,
which are used as benchmarks for fixed income Duration of a Zero-Coupon Bond
investments. The yield curve, in conjunction with
the credit spread, is used for pricing corporate
bonds. Now that you have a better understanding
of the relationship between interest rates, bond
prices and yields, we are ready to examine the
degree to which bond prices change with respect
to a change in interest rates.

Read more: Advanced Bond Concepts: Term

Structure of Interest Rates |
Investopedia http://www.investopedia.com/univer
sity/advancedbond/advancedbond4.asp#ixzz4ZO
T0MH9e
Follow us: Investopedia on Facebook
Advanced Bond Concepts: Duration
The term duration has a special meaning in the
context of bonds. It is a measurement of how
long, in years, it takes for the price of a bond to
be repaid by its internal cash flows. It is an
important measure for investors to consider, as
bonds with higher durations carry more risk and
have higher price volatility than bonds with lower
durations.
For each of the two basic types of bonds the
duration is the following:
The red lever above represents the four-year time
period it takes for a zero-coupon bond to mature.
The money bag balancing on the far right
represents the future value of the bond, the
amount that will be paid to the bondholder at
maturity. The fulcrum, or the point holding the
lever, represents duration, which must be
positioned where the red lever is balanced. The
fulcrum balances the red lever at the point on the
time line at which the amount paid for the bond
and the cash flow received from the bond are
equal. The entire cash flow of a zero-coupon
bond occurs at maturity, so the fulcrum is located
directly below this one payment.

Duration of a Vanilla or Straight Bond

1. Zero-Coupon Bond Duration is equal to its
Consider a vanilla bond that pays coupons
time to maturity.
annually and matures in five years. Its cash flows
consist of five annual coupon payments and the
2. Vanilla Bond - Duration will always be less
last payment includes the face value of the bond.
than its time to maturity.

The moneybags represent the cash flows you will
receive over the five-year period. To balance the
red lever at the point where total cash flows equal
the amount paid for the bond, the fulcrum must
be farther to the left, at a point before maturity.
Unlike the zero-coupon bond, the straight bond
pays coupon payments throughout its life and
therefore repays the full amount paid for the bond
sooner.
Factors Affecting Duration
It is important to note, however, that duration
changes as the coupons are paid to the
bondholder. As the bondholder receives a
coupon payment, the amount of the cash flow is
no longer on the time line, which means it is no
longer counted as a future cash flow that goes
towards repaying the bondholder. Our model of
the fulcrum demonstrates this: as the first coupon
payment is removed from the red lever and paid
to the bondholder, the lever is no longer in
balance because the coupon payment is no
longer counted as a future cash flow.
The fulcrum must now move to the right in order
to balance the lever again:
Duration increases immediately on the day a
coupon is paid, but throughout the life of the
bond, the duration is continually decreasing as
time to the bond's maturity decreases. The
movement of time is represented above as the
shortening of the red lever. Notice how the first
diagram had five payment periods and the above
diagram has only four. This shortening of the time
line, however, occurs gradually, and as it does,
duration continually decreases. So, in summary,
duration is decreasing as time moves closer to
maturity, but duration also increases momentarily
on the day a coupon is paid and removed from
the series of future cash flows - all this occurs
until duration, eventually converges with the
bond's maturity. The same is true for a zero-
coupon bond
 duration is calculated by adding the results
Duration: Other factors of multiplying the present value of each
Besides the movement of time and the payment cash flow by the time it is received and
of coupons, there are other factors that affect a dividing by the total price of the security.
bond's duration: the coupon rate and its yield. The formula for Macaulay duration is as
Bonds with high coupon rates and, in turn, high follows:
yields will tend to have lower durations than
bonds that pay low coupon rates or offer low
yields. This makes empirical sense, because
when a bond pays a higher coupon rate or has a
high yield, the holder of the security receives n = number of cash flows
repayment for the security at a faster rate. The t = time to maturity
C = cash flow
diagram below summarizes how duration i = required yield
changes with coupon rate and yield. M = maturity (par) value
P = bond price

Remember that bond price equals:

So the following is an expanded version of

Types of Duration Macaulay duration:
There are four main types of duration
calculations, each of which differ in the way they
account for factors such as interest rate changes
and the bond's embedded options or redemption
features. The four types of durations
are Macaulay duration, modified
duration, effective duration and key-rate duration.

Macaulay Duration
Example 1: Betty holds a five-year bond
The formula usually used to calculate a
with a par value of $1,000 and coupon rate
bond\'s basic duration is the Macaulay
of 5%. For simplicity, let's assume that the
duration, which was created by Frederick
coupon is paid annually and that interest
Macaulay in 1938, although it was not
rates are 5%. What is the Macaulay duration
commonly used until the 1970s. Macaulay
of the bond?
= 4.55 years
Fortunately, if you are seeking the Macaulay
duration of a zero-coupon bond, the
duration would be equal to the bond's
maturity, so there is no calculation required.
Modified Duration
Modified duration is a modified version of
the Macaulay model that accounts for
changing interest rates. Because they affect
yield, fluctuating interest rates will affect
duration, so this modified formula shows
how much the duration changes for each
percentage change in yield. For bonds
without any embedded features, bond price
and interest rate move in opposite
directions, so there is an inverse
relationship between modified duration and
an approximate 1% change in yield.
Because the modified duration formula
shows how a bond's duration changes in
relation to interest rate movements, the
formula is appropriate for investors wishing
to measure the volatility of a particular bond.
Modified duration is calculated as the
following:
OR
Let's continue to analyze Betty's bond and
run through the calculation of her modified
duration. Currently her bond is selling at
$1,000, or par, which translates
to a yield to maturity of 5%. Remember that
we calculated a Macaulay duration of 4.55.
= 4.33 years
Our example shows that if the bond's yield
changed from 5% to 6%, the duration of the
bond will decline to 4.33 years. Because it
calculates how duration will change when
interest increases by 100 basis points, the interest rates. The key-rate method is most
modified duration will always be lower than often used for portfolios such as the bond
the Macaulay duration. ladder, which consists of fixed-income
securities with differing maturities. Here is
Effective Duration the formula for key-rate duration:
The modified duration formula discussed
above assumes that the expected cash
flows will remain constant, even if prevailing
interest rates change; this is also the case
for option-free fixed-income securities. On The sum of the key-rate durations along the
the other hand, cash flows from securities curve is equal to the effective duration.
with embedded options or redemption
Duration and Bond Price Volatility
features will change when interest rates
More than once throughout this tutorial, we have
change. For calculating the duration of
established that when interest rates rise, bond
these types of bonds, effective duration is
prices fall, and vice versa. But how does one
the most appropriate.
determine the degree of a price change when
interest rates change? Generally, bonds with a
Effective duration requires the use of
high duration will have a higher price fluctuation
binomial trees to calculate the option-
than bonds with a low duration. But it is important
adjusted spread (OAS). There are entire
to know that there are also three other factors
courses built around just those two topics,
that determine how sensitive a bond's price is to
so the calculations involved for effective
changes in interest rates. These factors are term
duration are beyond the scope of this
to maturity, coupon rate and yield to maturity.
tutorial. There are, however, many programs
Knowing what affects a bond's volatility is
available to investors wishing to calculate
important to investors who use duration-
effective duration.
based immunization strategies, which we discuss
below, in their portfolios.
Key-Rate Duration
The final duration calculation to learn is key-
rate duration, which calculates the spot Factors 1 and 2: Coupon rate and Term
durations of each of the 11 "key" maturities to Maturity
along a spot rate curve. These 11 key If term to maturity and a bond\'s initial price
maturities are at the three-month and one, remain constant, the higher the coupon, the
two, three, five, seven, 10, 15, 20, 25, and lower the volatility, and the lower the
30-year portions of the curve. coupon, the higher the volatility. If the
coupon rate and the bond\'s initial price are
In essence, key-rate duration, while holding constant, the bond with a longer term to
the yield for all other maturities constant, maturity will display higher price volatility
allows the duration of a portfolio to be and a bond with a shorter term to maturity
calculated for a one-basis-point change in will display lower price volatility.
 Therefore, if you would like to invest in a
bond with minimal interest rate risk, a bond
with high coupon payments and a short
term to maturity would be optimal. An
investor who predicts that interest rates will
decline would best potentially capitalize on
a bond with low coupon payments and a
long term to maturity, since these factors
would magnify a bond\'s price increase.
Factor 3: Yield to Maturity (YTM)
The sensitivity of a bond\'s price to changes
in interest rates also depends on its yield to
maturity. A bond with a high yield to maturity
will display lower price volatility than a bond
with a lower yield to maturity, but a similar
coupon rate and term to maturity. Yield to
maturity is affected by the bond\'s credit
rating, so bonds with poor credit ratings will
have higher yields than bonds with excellent
credit ratings. Therefore, bonds with poor
credit ratings typically display lower price
volatility than bonds with excellent credit
ratings.
All three factors affect the degree to which bond
price will change in the face of a change in
prevailing interest rates. These factors work
together and against each other. Consider the
chart below:
So, if a bond has both a short term to maturity
and a low coupon rate, its characteristics have
opposite effects on its volatility: the low coupon
raises volatility and the short term to maturity
lowers volatility. The bond's volatility would then
be an average of these two opposite effects.
Immunization
As we mentioned in the above section, the
interrelated factors of duration, coupon rate, term
to maturity and price volatility are important for
those investors employing duration-based
immunization strategies. These strategies aim to
match the durations of assets and liabilities within
a portfolio for the purpose of minimizing the
impact of interest rates on the net worth. To
create these strategies, portfolio managers use
Macaulay duration.
For example, say a bond has a two-year term
with four coupons of $50 and a par value of
$1,000. If the investor did not reinvest his or her
proceeds at some interest rate, he or she would
have received a total of $1200 at the end of two
years. However, if the investor were to reinvest
each of the bond cash flows until maturity, he or
she would have more than $1200 in two years.
Therefore, the extra interest accumulated on the
reinvested coupons would allow the bondholder
to satisfy a future $1200 obligation in less time
than the maturity of the bond.
Understanding what duration is, how it is used
and what factors affect it will help you to
determine a bond's price volatility. Volatility is an
important factor in determining your strategy for
capitalizing on interest rate movements.
Furthermore, duration will also help you to
determine how you can protect your portfolio from
interest rate risk.

Read more: Advanced Bond Concepts: Duration |

Investopedia http://www.investopedia.com/univer
sity/advancedbond/advancedbond5.asp#ixzz4ZO
TA9AhE
Follow us: Investopedia on Facebook
Advanced Bond Concepts: Convexity

For any given bond, a graph of the relationship

between price and yield is convex. This means
that the graph forms a curve rather than a
straight-line (linear). The degree to which the
graph is curved shows how much a bond's yield
changes in response to a change in price. In this
section we take a look at what
affects convexity and how investors can use it to
compare bonds.

Convexity and Duration

If we graph a tangent at a particular price of the
bond (touching a point on the curved price-yield
curve), the linear tangent is the bond's duration,
which is shown in red on the graph below. The
exact point where the two lines touch
represents Macaulay duration. Modified duration,
as we saw in the preceding section of this
tutorial, must be used to measure how duration is
affected by changes in interest rates. But
modified duration does not account for large
changes in price. If we were to use duration to
estimate the price resulting from a significant
change in yield, the estimation would be
inaccurate. The yellow portions of the graph
show the ranges in which using duration for
estimating price would be inappropriate.
Furthermore, as yield moves further from Y*, the
yellow space between the actual bond price and
the prices estimated by duration (tangent line)
increases.
The convexity calculation, therefore, accounts for
the inaccuracies of the linear duration line. This
calculation that plots the curved line uses a
Taylor series, a very complicated calculus theory
that we won't be describing here. The main thing
for you to remember about convexity is that it
shows how much a bond's yield changes in
response to changes in price.
Properties of Convexity
Convexity is also useful for comparing bonds. If
two bonds offer the same duration and yield but
one exhibits greater convexity, changes in
interest rates will affect each bond differently. A
bond with greater convexity is less affected by
interest rates than a bond with less convexity.
Also, bonds with greater convexity will have a
higher price than bonds with a lower convexity,
regardless of whether interest rates rise or fall.
This relationship is illustrated in the following
diagram:
As you can see Bond A has greater convexity
than Bond B, but they both have the same price
and convexity when price equals *P and yield
equals *Y. If interest rates change from this point
by a very small amount, then both bonds would
have approximately the same price, regardless of
the convexity. When yield increases by a large
amount, however, the prices of both Bond A and
Bond B decrease, but Bond B's price decreases
more than Bond A's. Notice how at **Y the price
of Bond A remains higher, demonstrating that
investors will have to pay more money (accept a
lower yield to maturity) for a bond with greater
convexity.
What Factors Affect Convexity?
Here is a summary of the different kinds of
convexities produced by different types of bonds:
1) The graph of the price-yield relationship for a
plain vanilla bond exhibits positive convexity. The
price-yield curve will increase as yield decreases,
and vice versa. Therefore, as market yields
decrease, the duration increases (and vice
versa).
 company would have to reissue new bonds at a
higher interest rate. Remember that as bond
yields increase, bond prices are decreasing and
thus interest rates are increasing. A bond issuer
would find it most optimal, or cost-effective, to call
the bond when prevailing interest rates have
declined below the callable bond's interest
(coupon) rate. For decreases in yields below *Y,
the graph has negative convexity, as there is a
higher risk that the bond issuer will call the bond.
2) In general, the higher the coupon rate, the
As such, at yields below *Y, the price of a callable
lower the convexity of a bond. Zero-
bond won't rise as much as the price of a plain
coupon bonds have the highest convexity.
vanilla bond.

3) Callable bonds will exhibit negative convexity

Convexity is the final major concept you need to
at certain price-yield combinations. Negative
know for gaining insight into the more technical
convexity means that as market yields decrease,
aspects of the bond market. Understanding even
duration decreases as well. See the chart below
the most basic characteristics of convexity allows
for an example of a convexity diagram of callable
the investor to better comprehend the way in
bonds.
which duration is best measured and how
changes in interest rates affect the prices of both
plain vanilla and callable bonds.
Advanced Bond Concepts: Formula Cheat
Sheet

Below is our formula cheat sheet for bond

analysis.

Actual/Actual Day Count (Non-leap year)

Actual/Actual Day Count (Leap year)

Remember that for callable bonds, which we

discuss in our section detailing types of bonds,
modified duration can be used for an accurate Bond
estimate of bond price when there is no chance Price
30/360 Day Count
that the bond will be called. In the chart above,
the callable bond will behave like an option-free
bond at any point to the right of *Y. This portion of
the graph has positive convexity because, at
yields greater than *Y, a company would not call Accrued Interest (AI)

its bond issue: doing so would mean the

Adjusted Current Yield Bond prices may be either dirty or clean,
depending on when the last coupon
Current Yield

Key Rate Duration payment was made and how much

interest has been accrued.
Macaulay Duration
Yiel
d is
Modified Duration a

measure of the income an investor

receives if he or she holds a bond
Yield until maturity; required yield is the
minimum income a bond must offer in
order to attract investors.
Yield to Call
Current yield is a basic calculation of the
annual percentage return an investor

Yield to Put

Zero Coupon Bond Price

receives from his or her initial investment.

Advanced Bond Concepts: Conclusion Yield to maturity is the resulting interest

rate an investor receives if he or she
You have now learned some of the more invests all coupon payments at a constant
advanced topics associated with bonds. Let's run interest rate until the bond matures.

through a quick recap of what we discussed in

this tutorial:
Bonds vary according to characteristics
such as the type of issuer, priority, coupon
rate, and redemption features.
The term structure of interest rates, or
yield curve, is useful in determining the
direction of market interest rates.
The yield curve demonstrates the concept
of the credit spread between corporate
and government fixed income securities.
 Duration is the time in years it takes a
bond's cash flows to repay the investor the
total price of the bond.
A convex line is formed when the yield
and price of a bond is graphed, and this
line can exhibit positive or
negative convexity.
If we draw a line tangent to the convex
price-yield curve, we draw a line that is
equal to duration. The relationship
between the linear duration line and the
convex price-yield curve allows us to
determine the accuracy associated with
using modified duration.
Bonds with greater convexity exhibit
less volatility when there is a change in
interest rates.
Convexity
Convexity is the measure of the curve in the
relationship between a bonds price and its yield.
Consider the price and yield of Bond A on a
graph, where price is marked on the vertical axis,
and yield on the horizontal. A bonds price and
yield are inversely related, so as its price
decreases, its yield increases. But the rate at
which this happens slows over time. And
inversely, the rate at which a bonds price
increases as its yield decreases accelerates. The
result is a curved line.
The duration of a bond is the length of time it
takes for a bonds cash flow to repay the investor.
As a bonds yield increases, its duration
decreases in a straight line. As its yield
decreases, its duration increases, also in a
straight line. The curvature of the convexity line
accounts for the difference between the bonds
actual price at the time of price decrease or
increase, and what the straight duration line
states its price would be at each point.
Convexity is important because it reveals the
systemic risk to which a portfolio is exposed. As
convexity grows, so, too, does the portfolios
systemic risk. As it decreases, a portfolios
exposure to market interest rates decreases. In
general, a bond with a higher convexity will have
a higher price when interest rates rise or fall. A
bond with a higher coupon rate will have lower
convexity.
Simple Math for
Fixed-Coupon
Corporate
Bonds
Bonds, in general, are simply debt
instruments that allow businesses, or the
government, to finance their capital needs by
finding investors who agree to loan them an
amount in exchange for interest for a period,
before returning the principal amount of the loan
in full. There are specific rates and periods that
the bond issuer and investor agree to. Though
the numbers may appear confusing at first,
breaking down the important figures and some
simple calculations can help make the math
behind corporate bonds a bit easier to
understand. Especially when it comes to figuring
out which corporate bonds are worth investing in
and which do not offer a strong enough ROI.
Defining Some Important Terms
Current yield: This refers to the current yield a
corporate bond provides based specifically on its
market price and coupon rate as opposed
to basing it on par or face value. This yield is
determined by taking the bonds annual interest
and dividing that amount by its current market
price. To make this clear, consider this simple
example: a $1000 bond that sells for $900 and
pays a 7% coupon (thats $70 a year), would
have a current yield of 7.77%. This is $70 (annual
interest) divided by $900 (current price).
Yield to Call: The yield to call refers to the
bonds yield if its redeemed at the first possible
call date instead of its date of maturation. The
date used in this calculation is typically the
earliest possible call date, not the final date
where it reaches full value. Its not uncommon for
prudent investors to determine both a corporate
bonds yield to call and yield to maturation before
making a final decision about investing in a bond.
A range of possible yields become evident with
the yield to call on the low end. Whereas, the
yield to maturity is used to determine the possible
high-end yield of the bond. According to Standard
& Poors Financial Services LLC, 2015 the yield
to call will assume that corporate bond is held
until the call date and that the reinvested cash is
done so at the same rate as the original yield to
call.
Yield to Maturity (YTM): This refers to the
interest rate for equating a bonds price to its
present cash flow value. When the phrase yield
to maturity is used, this means its assumed that
the corporate bond will be held until it matures.
Additionally, this term also assumes all interim
cash flows are reinvested at an equivalent rate to
the yield upon maturation. If the corporate bond
isnt held to maturity, or the cash flows become
reinvested at different rates from the yield to
maturity rate, then the investor's yield will differ
from the yield to maturity. It's important to note
that the calculation for a yield to maturity includes
consideration for any capital losses, gains, or
income investors experience when holding a
bond all the way to maturation).
Yield to Worst (YTW): This refers to the lowest
possible yield a corporate bond can generate.
This measure is typically called before maturity.
Duration: This measures a bonds sensitivity to
changes in interest rates. Duration specifically
refers to the weighted average term that it takes a
securitys cash flows to mature. This average
term is weighted specifically by the present cash
flow values percentage of the securitys price.
This means that the longer, or greater, the
duration of a bond is, the more vulnerable it is to
changes in interest rates. According to Standard
& Poors Financial Services LLC, 2015, duration,
therefore, is used to estimate what exactly
changes in a bonds price in percentage given a
1% fluctuation in the interest rate. For example: if
a corporate bonds duration is 3, then it would be
expected to move by 3% for every 1% that the
interest rate moves.
Other Factors to Be Considered
Maturity date: The date of maturation is the date
you receive your principal investment back on a
corporate bond. It also, therefore, determines
how long you will receive interest payments on
that capital. Of course, there are some
exceptions to how this works. For example, some
bonds or securities are considered callable.
This means the issuer of the bond can pay back
the principal at specific times they before the
actual maturity. Without any doubt, it is important
for investors to determine if a corporate bond is
callable before the investment in such securities.
Coupon: This refers to the annual amount of
interest a bond pays out and is often expressed
as a percentage of the bonds face value. This
means a $1000 corporate bond that has a fixed
6% coupon pays $60 a year for the duration of
the bond. Most interest payments are
made semiannually. So in this example, investors
would likely receive a $30 payment, twice a year.
As above-mentioned, there is also a current yield
that can deviate from the coupon, which is also
called the nominal yield in contrast to the current
yield. This comes about because bonds, once
issued, can be traded and resold which may
cause their value to fluctuate. It is important to
keep in mind that changes in the current yield do
not affect the coupon as the face value, and
annual payments are fixed from the date of
issuance.
Par Value: This is the bonds face valuethe
amount written in the issuers corporate charter.
This amount is of particular importance for fixed-
income bonds where it is used to determine the
bonds value upon maturation as well as the
number of coupon payments until that time. The
normal par value for a bond is either $100 or
$1000. The current market price of any corporate
bond may be above or below the par value at any
time depending on many different factors like the
current interest rate, the credit rating of the
bonds issuer, the quality of the corporation and
the time to maturity.
The buying price or current price: This only
refers to the amount an investor pays for the
corporate bond (or any other security). For
investors, this is the important amount as the
current price ultimately determines their
potential ROI. If the buying price is much higher
than the par value, then the opportunity most
likely does not present as great a possibility of
returns.
Coupon frequency and the date of interest
payment: It's important that all investors are
aware of the coupon frequency as well as the
exact dates of interest payments on the corporate
bonds they hold in their portfolio. This information
can be found for instance in the prospectus of the
issuer.
The Bottom Line
Using the information mentioned above, investors
can precisely determine the cash flows coming in
by the interest payments of different corporate
bonds. As noted, most corporate bonds pay out
semiannually; however, the alternatives
are annually or quarterly: a corporate bond
(annual coupon frequency) with a $1000 face
value and a fixed 6% coupon pays out $60 once
a year at the predetermined date of interest
payment. A corporate bond (quarterly coupon
frequency) with a $1000 face value and a fixed
6% coupon pays out $15 four times a year, also
at the predetermined dates of interest payment.
In fact, by gathering the relevant data for all
corporate bonds in a portfolio, investors may
obtain a clear payout structure for their portfolio
as they receive precise information on the date
and amount of each interest coupon they will
receive. By summing up accordingly, the investor
will be able to determine for instance the exact
amount of monthly interest received. These are
excellent methods to find out important figures.
Why You
Should Avoid
Fixating on
Bond Portfolio
Duration
The Federal Reserve is widely expected to begin
hiking interest rates this year, which typically has
a negative impact on bond prices. In response,
many financial advisors have been focused
on duration and interest rate sensitivity when
analyzing their clients bond portfolios. The
problem with this approach is that non-
government and government bonds often dont
act in the same manner.
For instance, the 2008 economic crisis saw
government bonds gain nearly 28% and non-
government investment grade bonds fall nearly
4%, according to Morningstar, Inc. (MORN) data,
despite the similar durations, interest rate risk,
and other characteristics. The opposite dynamics
occurred in 2009 when the market snapped back.
The irony is that bonds are usually a part of a
clients portfolio designed to have less risk.
In this article, well take a look at why financial
advisors and their clients may want to look
beyond duration when evaluating bond portfolios.
Bond Duration Primer
Bond duration is a measure of how many years it
will take for the price of a bond to be repaid by
internal cash flows. In essence, duration
measures price sensitivity to yield changes by
measuring the approximate change of a
securitys price that will result from a 100 basis
point change in yield. Longer durations suggest
greater sensitivity to changes in interest rates and
vice versa. (For more, see: Advanced Bond
Concepts: Duration.)
For instance, a bond carrying an effective
duration of two years will rise 2% for every 1%
drop in its yield, while the price of a bond with a
five-year duration will rise 5% for every 1%
increase in its yield. If interest rates are expected
to fall, then duration is extended, and if interest
rates are expected to rise, then duration is
reduced. Low duration strategies are generally
less volatile than long duration strategies. (For
more, see: Understanding Interest Rates,
Inflation and the Bond Market.)
Duration Doesnt Always Work
Standard bond valuation formulas look at a
simple set of criteria, including interest rates,
yield, and duration to determine expected cash
flows that can be discounted to present value.
When looking at Treasury bonds, these dynamics
are extremely predictable and work pretty well at
approximating valuations, although raw
economics can have an impact during a so-called
flight to safety. (For more, see: Use Duration
and Convexity to Measure Bond Risk.)
When analyzing other types of bonds, its not
always appropriate to use duration as the only
metric, particularly when referencing Treasury
bonds. Treasury bonds may be effectively used
as proxies during non-volatile times for
investment-grade bonds, but these comparisons
can fall apart during volatile periods (when they
really matter), such as during the 2008 decline
and again during the 2009 recovery.
Bond portfolio durations are also simply a
weighted average of its underlying bonds, which
have various weights and maturities.
Consequently, the gain or loss predicted by
analyzing duration will only be accurate if the
market yields change the same amount for every
bond across the maturity spectrum a scenario
thats highly uncommon which makes looking
at the fine print of these funds very important.
(For more, see: Investments with Low Interest
Rate Risk and High Yields.)
Consider Other Risk Factors
Duration is certainly an important consideration
when interest rates are expected to rise or fall,
but there are many other risks that should also be
carefully evaluated, including inflation risk, default
risk, and call risk, among others. While some of
these risks may not apply to U.S. government
bonds like default risk corporate bonds and
bond funds must be discounted to account for
these risks. (For more, see: Interest Rates and
Your Bond Investments.)
Bond funds also have a number of separate
dynamics that should be carefully evaluated,
such as risk concentration among individual
bonds or bond types. In some cases, credit risk
can be mitigated through diversification, but it
doesnt make these risks disappear entirely.
Foreign exchange risks and other risks may apply
to specialized funds that invest in foreign markets
or exotic bonds.
For financial advisors, bond choices should look
beyond yield to include safety as it applies to a
clients financial objectives. Bonds are often
intended to be a safety net of sorts to hedge
against a decline in equities, but the safety net
may not be very effective if the bond portfolio
consists of risky junk bond issues. In summary,
its tempting to look at duration and yield, but
there are many other important factors. (For
more, see: Six Biggest Bond Risks.)
The Bottom Line
Duration can be useful for estimating the interest
rate risks associated with bonds that are closely
tracking Treasury bonds. When investors deviate
too far from those bonds, the metric becomes far
less useful at encompassing all of the different
types of risks being measured. Financial advisors
and their clients should then focus on a bond
funds portfolio rather than relying on any single
metric like duration. (For more, see: Is it Time to
Buy Floating Rate Bonds?)
Portfolo managment
17.1 Introduction
Welcome to the wild and wonderful world of Debt
Securities. In this part of the guide you will learn
the basic definitions and calculation concerning
fixed income securities. This study guide is
designed so that every LOS is answered.
However, if you do not understand a concept, be
sure to refer to the reading recommended by the
CFA Institute or one of Investopedia's tutorials.
 Formula 17.1
We'll start with the Example: Real risk-
Real risk free rate (Rf) = (1 + nominal risk-free rate) - 1
basics of debt free rate of return
(1 + inflation rate)
investments in the first Determine the real
half of the section. In risk-free rate if the
the second half, we'll examine bond analysis and nominal risk-free rate is 8% and the inflation rate
valuation. The first portion of this section will is 3%.
describe a bond's features. The next portion will
mainly cover the 10 risks of debt investments Answer:
before moving on to more challenging concepts.
Rf = (1 + 0.08) - 1 = 4.85%
(1 + 0.03)
If the topic of debt securities is new to you or you
haven't reviewed its theory for a while, you may
Nominal risk-free rate of return (Rnominal)
want to check out the following tutorial: Bond and
This is simply the real risk-free rate of return
Debt Basics
adjusted for inflation.

Read more: Introduction - CFA Level 1 |

Investopedia http://www.investopedia.com/exam-
guide/cfa-level-1/fixed-income-
investments/default.asp#ixzz4ZOUnngkg
Follow us: Investopedia on Facebook
17.2 Rate of Return Basics
The Required Rate of ReturnThe required rate
of return is the nominal rate of return that an
investor needs in order to make an investment
worthwhile.
Formula 17.2
Nominal risk-free rate = (1 + risk-free rate) x (1 +
rate of inflation) - 1
Example: Nominal risk-free rate of return
Determine the nominal risk-free rate of return if
the risk-free rate is 3% and the rate of inflation is
3%.
Answer:

This return varies over time and is comprised of Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%
the following:

Real risk-free rate

Read more: Rate of Return Basics - CFA Level 1
Inflation premium |
Investopedia http://www.investopedia.com/exam-
Risk premium.
guide/cfa-level-1/portfolio-management/rate-of-
return-basics.asp#ixzz4ZOUvsF4r
Real risk-free rate of return
Follow us: Investopedia on Facebook
The real risk-free rate of return (Rf) is the
minimum return an investor requires. This rate 17.3 The Risk Premium
does not take into account expected inflation and
the capital market environment. In an investment setting, an investor sets his
required rate of return as the base return he
requires from an investment. However, given the
usual uncertainty in the market, it is difficult to
meet that required rate of return exactly. As such,
an investor would set his return above his
required rate of return to diminish the risk that his
required rate of return will not be met. The excess
return above the investor's required rate of return
is known as the risk premium.
The fundamental sources of risk that contribute to
the need of the risk premium, such as:
1. Business risk
2. Financial risk
3. Liquidity risk
4. Exchange rate risk
5. Political risk.
These risks comprise systematic risk, and cannot
be avoided through diversification since they
affect the entire market.
1. Business Risk: Business risk is the risk
that a business' cash flow will not meet its
needs due to uncertainty in the company's
business lines.
2. Financial Risk: Financial risk is the risk to
equity holders as a company increases its
debt load. As debt load increases, interest
expense also increases, leading to less
income to be paid out to investors.
3. Liquidity Risk: Liquidity risk is the
uncertainty around the ability to sell an
investment. The more liquid an investment
is the easier it is to sell.
4. Exchange-Rate Risk: Exchange-rate risk
is the risk a company faces when it has
businesses in other countries. When a
company is in the business of producing
or buying products in a country other than
its own, a company can face exchange-
rate risk when in the process when it
needs to exchange currency to transact
business as a part of its normal business
routine.
5. Political Risk: Political risk is the risk of
changes in the political environment of a
country in which company transacts its
businesses. This risk could be caused by
changes in laws relating to a specific
business or even more serious as a
country revolution that would cause
disruption in a company's operations.
Learn how the expected extra return on stocks is
measured and why academic studies usually
estimate a low premium in the article Risk
Premium.
Read more: The Risk Premium - CFA Level 1 |
Investopedia http://www.investopedia.com/exam-
guide/cfa-level-1/portfolio-management/risk-
premium.asp#ixzz4ZOV1exNf
Follow us: Investopedia on Facebook
17.4 The Security Market Line (SML)
The security market line (SML) is the line that
reflects an investment's risk versus its return, or
the return on a given investment in relation to
risk. The measure of risk used for the security
market line is beta.
The line begins with the risk-free rate (with zero
risk) and moves upward and to the right. As the
risk of an investment increases, it is expected
that the return on an investment would increase.
An investor with a low risk profile would choose
an investment at the beginning of the security
market line. An investor with a higher risk profile
would thus choose an investment higher along
the security market line.
Figure 17.1: Security Market Line
Given the SML reflects the return on a given
investment in relation to risk, a change in the
slope of the SML could be caused by the risk
premium of the investments. Recall that the risk
premium of an investment is the excess return
required by an investor to help ensure a required
rate of return is met. If the risk premium required
by investors was to change, the slope of the SML
would change as well.
When a shift in the SML occurs, a change that
affects all investments' risk versus return profile
has occurred. A shift of the SML can occur with
changes in the following:
1. Expected real growth in the economy.
2. Capital market conditions.
3. Expected inflation rate.
17.5 The Portfolio Management Process
The portfolio management process is the process
an investor takes to aid him in meeting his
investment goals.
The procedure is as follows:
1. Create a Policy Statement -A policy
statement is the statement that contains
the investor's goals and constraints as it
relates to his investments.
2. Develop an Investment Strategy - This
entails creating a strategy that combines
the investor's goals and objectives with
current financial market and economic
conditions.
3. Implement the Plan Created -This
entails putting the investment strategy to
work, investing in a portfolio thatmeets the
client's goals and constraint requirements.
4. Monitor and Update the Plan -Both
markets and investors' needs change as
time changes. As such, it is important to
monitor for these changes as they occur
and to update the plan toadjust for the
changes that have occurred.
Policy Statement
A policy statement is the statement that contains
the investor's goals and constraints as it relates
to his investments. This could be considered to
be the most important of all the steps in the
portfolio management process. The statement
requires the investor to consider his true financial
needs, both in the short run and the long run. It
helps to guide the investment portfolio manager
in meeting the investor's needs. When there is
market uncertainty or the investor's needs
change, the policy statement will help to guide
the investor in making the necessary adjustments
the portfolio in a disciplined manner.
Expressing Investment Objectives in Terms of
Risk and Return
Return objectives are important to determine.
They help to focus an investor on meeting his
financial goals and objectives. However, risk must
be considered as well. An investor may require a
high rate of return. A high rate of return is
typically accompanied by a higher risk. Despite
the need for a high return, an investor may be
uncomfortable with the risk that is attached to
that higher return portfolio. As such, it is
important to consider not only return, but the risk
of the investor in a policy statement.
Factors Affecting Risk Tolerance
An investor's risk tolerance can be affected by
many factors:
Age- an investor may have lower risk
tolerance as they get older and financial
constraints are more prevalent.
Family situation - an investor may have
higher income needs if they are
supporting a child in college or an elderly
relative.
Wealth and income - an investor may
have a greater ability to invest in a
portfolio if he or she has existing wealth or
high income.
Psychological - an investor may simply
have a lower tolerance for risk based on
his personality.
17.6 Return Objectives and Investment
Constraints
Return objectives can be divided into the
following needs:
1. Capital Preservation - Capital
preservation is the need to maintain
capital. To accomplish this objective, the
return objective should, at a minimum, be
equal to the inflation rate. In other words,
nominal rate of return would equal the
inflation rate. With this objective, an
investor simply wants to preserve his
existing capital.
2. Capital Appreciation -Capital
appreciation is the need to grow, rather
than simply preserve, capital. To
accomplish this objective, the return
objective should be equal to a return that
exceeds the expected inflation. With this
objective, an investor's intention is to grow
his existing capital base.
3. Current Income -Current income is the
need to create income from the investor's
capital base. With this objective, an
investor needs to generate income from
his investments. This is frequently seen
with retired investors who no longer have
income from work and need to generate
income off of their investments to meet
living expenses and other spending
needs.
4. Total Return - Total return is the need to
grow the capital base through both capital
appreciation and reinvestment of that
appreciation.
Investment Constraints
When creating a policy statement, it is important
to consider an investor's constraints. There are
five types of constraints that need to be
considered when creating a policy statement.
They are as follows:
1. Liquidity Constraints - Liquidity
constraints identify an investor's need for
liquidity, or cash. For example, within the
next year, an investor needs $50,000 for
the purchase of a new home. The $50,000
would be considered a liquidity constraint
because it needs to be set aside (be
liquid) for the investor.
2. Time Horizon - A time horizon constraint
develops a timeline of an investor's
various financial needs. The time horizon
also affects an investor's ability to accept
risk. If an investor has a long time horizon,
the investor may have a greater ability to
accept risk because he would have a
longer time period to recoup any losses.
This is unlike an investor with a shorter
time horizon whose ability to accept risk
may be lower because he would not have
the ability to recoup any losses.
3. Tax Concerns - After-tax returns are the
returns investors are focused on when
creating an investment portfolio. If an
investor is currently in a high tax bracket
as a result of his income, it may be
important to focus on investments that
would not make the investor's situation
worse, like investing more heavily in tax-
deferred investments.
4. Legal and Regulatory - Legal and
regulatory factors can act as an
investment constraint and must be
considered. An example of this would
occur in a trust. A trust could require that
no more than 10% of the trust be
distributed each year. Legal and
regulatoryconstraints such as this one
often can't be changed and must not be
overlooked.
5. Unique Circumstances - Any special
needs or constraints not recognized in any
of the constraints listed above would fall in
this category. An example of a unique
circumstance would be the constraint an
investor might place on investing in any
company that is not socially responsible,
such as a tobacco company.
The Importance of Asset Allocation
Asset Allocation is the process of dividing a
portfolio among major asset categories such as
bonds, stocks or cash. The purpose of asset
allocation is to reduce risk by diversifying the
portfolio.
The ideal asset allocation differs based on the
risk tolerance of the investor. For example, a
young executive might have an asset allocation of
80% equity, 20% fixed income, while a retiree
would be more likely to have 80% in fixed income
and 20% equities.
Citizens in other countries around the world
would have different asset allocation strategies
depending on the types and risks of securities
available for placement in their portfolio. For
example, a retiree located in the United
States would most likely have a large portion of
his portfolio allocated to U.S. treasuries, since the
U.S. Government is considered to have an
extremely low risk of default. On the other hand,
a retiree in a country with political unrest would
most likely have a large portion of their portfolio
allocated to foreign treasury securities, such as
Look Out!
Risk of a portfolio is affected by the risk of each inv
correlation with the other investments in the portfol
that of the U.S. Investors make decision based on an
investment's risk and return, therefore, an
17.7 Portfolio Management Theories investor's utility curve is based on risk and
Risk Aversion return.
Risk aversion is an investor's general desire to
avoid participation in "risky" behavior or, in this
The Efficient Frontier
case, risky investments. Investors typically wish
Markowitz' work on an individual's investment
to maximize their return with the least amount of
behavior is important not only when looking at
risk possible. When faced with two investment
individual investment, but also in the context of a
opportunities with similar returns, good investor
portfolio. The risk of a portfolio takes into account
will always choose the investment with the least
each investment's risk and return as well as the
risk as there is no benefit to choosing a higher
investment's correlation with the other
level of risk unless there is also an increased
investments in the portfolio.
level of return.
A portfolio is considered efficient if it gives the
Insurance is a great example of investors' risk investor a higher expected return with the same
aversion. Given the potential for a car accident, or lower level of risk as compared to another
an investor would rather pay for insurance and investment. The efficient frontieris simply a plot
minimize the risk of a huge outlay in the event of of those efficient portfolios, as illustrated below.
an accident.
Figure 17.2: Efficient Frontier
Markowitz Portfolio Theory
Harry Markowitz developed the portfolio model.
This model includes not only expected return, but
also includes the level of risk for a particular
return. Markowitz assumed the following about an
individual's investment behavior:

Given the same level of expected return,

an investor will choose the investment with
the lowest amount of risk.

Investors measure risk in terms of an

investment's variance or standard
deviation.
For each investment, the investor can
quantify the investment's expected return
and the probability of those returns over a
specified time horizon.
Investors seek to maximize their utility.
While an efficient frontier illustrates each of the
efficient portfolios relative to risk and return
levels, each of the efficient portfolios may not be
appropriate for every investor. Recall that when
creating an investment policy, return and risk
were the key objectives. An investor's risk profile
is illustrated with indifference curves. The optimal
portfolio, then, is the point on the efficient frontier
that is tangential to the investor's highest
 indifference curve. See our article: A Guide to Figure 3.3: Expected returns for Newco's stock
Portfolio Construction, for some essential steps price in the various states
when taking a systematic approach to
constructing a portfolio. Scenario
Probabili Expected
ty Return

Worst
10% 10%
Case

Base Case 80% 14%

erse investor will not be as risky as the optimal portfolio of an investor who is willing to
Best Case 10% 18%

Given the above assumptions, determine the

Read more: Portfolio Management Theories - expected return for Newco's stock.
CFA Level 1 |
Investopedia http://www.in Answer:
vestopedia.com/exam- Formula 17.4 E(R) = (0.10)(10%) +
guide/cfa-level-1/portfolio- (0.80)(14%) + (0.10)
management/portfolio- E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn (18%)
management- E(R) = 14.0%
theories.asp#ixzz4ZOVmGuCg
Follow us: Investopedia on Facebook The expected return for Newco's stock is 14%.
17.8 Portfolio Calculations

Individual Investment Portfolio

The expected return for an individual investment To determine the expected return on a portfolio,
is simply the sum of the probabilities of the the weighted average expected return of the
possible expected returns for the investment. assets that comprise the portfolio is taken.

+ .....+ pnRn
n actually will occur in state n

Example:
For Newco's stock, assume the following
potential returns.
Example: Figure: Expected return for Newco in various
Assume an investment manager has created a states
portfolio with the Stock A and Stock B. Stock A
has an expected return of 20% and a weight of Probabili Retur Expected
Scenario ty n Return
30% in the portfolio. Stock B has an expected
return of 15% and a weight of 70%. What is the Worst 10%
10% 0.01
expected return of the Case
portfolio?
Base Case 80% 14% 0.112
Formula 17.5
Answer: Best Case 10% 18% 0.018
Variance =
E(R) = (0.30)(20%) +
Where: Pn = probability of occurrence
(0.70)(15%)
Rn = return in n occurrence
= 6% + 10.5% = 16.5%
E(R) = expected return Answer:
The expected return of the
2 = (0.10)(0.10 - 0.14)2 + (0.80)
portfolio is 16.5%
(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2
= 0.0003
Computing Variance and Standard Deviation
for an Individual
The variance for Newco's stock is 0.0003.
To measure the risk of an investment, both the
variance and standard deviation for that
Given that the standard deviation of Newco's
investment can be calculated.
stock is simply the square root of the variance,
the standard deviation is 0.0179 or 1.79%.

Example: Variance and Standard Deviation of
an Investment
Given the following data for Newco's stock,
calculate the stock's variance and standard
deviation. The expected return based on the data
is 14%.
Covariance
The covariance is the measure of how two assets
relate (move) together. If the covariance of the
two assets is positive, the assets move in the
same direction. For example, if two assets have a
covariance of 0.50, then the assets move in the
same direction. If however the two assets have a
negative covariance, the assets move in opposite
directions. If the covariance of the two assets is
zero, they have no relationship.
 The correlation coefficient is the relative measure
of the relationship between two assets. It is
between +1 and -1, with a +1 indicating that the
two assets move completely together and a -1
indicating that the two assets move in opposite
directions from each other.

Example: Calculate the covariance between

two assets
Assume the mean return on Asset A is 10% and
the mean return on Asset B is 15%. Given the
following returns over the past 5 periods,
calculate the covariance for Asset A as it relates
to Asset B.

Returns

Ra Rb
N
Example: Calculate the correlation of Asset A
1 10% 18%
Answer: with Asset B.
2 15% 25% Given our covariance of 18 in the example above,
what is the correlation coefficient for Asset A
3 5%
Ra Rb 2% Ra- Avg Ra
N relative to Asset B if Asset A has a standard
4 13% 8% deviation of 4 and Asset B has a standard
1 10 18 0 deviation of 3.
5 8% 17%
2 15 25 5
Answer:
3 5 2 -5 Correlation coefficient = 18/(8)(4) = 0.563

4 13 8 3
Components of the Portfolio Standard
5 8 17 -2
Deviation Formula
Remember that when calculating the expected
Sum return of a portfolio, it is simply the sum of the
weighted returns of each asset in the portfolio.
Unfortunately, determining the standard deviation
The covariance would equal 18 (90/5). of a portfolio, it is not that simple. Not only are the
weights of the assets in the portfolio and the
standard deviation for each asset in the portfolio
Correlation
needed, the correlation of the assets in the
portfolio is also required to determine the portfolio
standard deviation.
The equation for the standard deviation for a two
asset portfolio is long, but should be memorized
for the exam.
17.9 Capital Market Theory
The capital market theory builds upon the
Markowitz portfolio model. The main
assumptions of the capital market theory are as
follows:
1. All Investors are Efficient
Investors - Investors follow Markowitz
idea of the efficient frontier and choose to
invest in portfolios along the frontier.
2. Investors Borrow/Lend Money at the
Risk-Free Rate - This rate remains static
for any amount of money.
3. The Time Horizon is equal for All
Investors - When choosing investments,
investors have equal time horizons for the
choseninvestments.
4. All Assets are Infinitely Divisible - This
indicates that fractional shares can be
purchased and the stocks can be infinitely
divisible.
5. No Taxes and Transaction Costs -
assume that investors' results are not
affected by taxes and transaction costs.
6. All Investors Have the Same
Probability for Outcomes -When
determining the expected return, assume
that all investors have the same probability
for outcomes.
7. No Inflation Exists - Returns are not
affected by the inflation rate in a capital
market as none exists in capital market
theory.
8. There is No Mispricing Within the
Capital Markets - Assume the markets
are efficient and that no mispricings within
the markets exist.
What happens when a risk-free asset is added
to a portfolio of risky assets?
To begin, the risk-free asset has a standard
deviation/variance equal to zero for its given level
of return, hence the "risk-free" label.
Expected Return - When the Risk-Free
Asset is Added
Given its lower level of return and its lower
level of risk, adding the risk-free asset to a
portfolio acts to reduce the overall return
of the portfolio.
Example: Risk-Free Asset and
Expected Return
Assume an investor's portfolio consists
entirely of risky assets with an expected
return of 16% and a standard deviation of
0.10. The investor would like to reduce the
level of risk in the portfolio and decides to
transfer 10% of his existing portfolio into
 the risk-free rate with an expected return
of 4%. What is the expected return of the
new portfolio and how was the portfolio's
expected return affected given the addition
of the risk-free asset?
Answer:
The expected return of the new portfolio
is: (0.9)(16%) + (0.1)(4%) = 14.4%
With the addition of the risk-free asset, the
expected value of the investor's portfolio
was decreased to 14.4% from 16%.
Standard Deviation - When the Risk-
Free Asset is Added
As we have seen, the addition of the risk-
free asset to the portfolio of risky assets
reduces an investor's expected return.
Given there is no risk with a risk-free
asset, the standard deviation of a portfolio
is altered when a risk-free asset is added.
Example: Risk-free Asset and Standard
Deviation
Assume an investor's portfolio consists
entirely of risky assets with an expected
return of 16% and a standard deviation of
0.10. The investor would like to reduce the
level of risk in the portfolio and decides to
transfer 10% of his existing portfolio into
the risk-free rate with an expected return
of 4%. What is the standard deviation of
the new portfolio and how was the
portfolio's standard deviation affected
given the addition of the risk-free asset?
deviation of the two-asset portfolio with a
risky asset is the weight of the risky assets
in the portfolio multiplied by the standard
deviation of the portfolio.
Standard deviation of the portfolio is: (0.9)
(0.1) = 0.09
Similar to the affect the risk-free asset had
on the expected return, the risk-free asset
also has the affect of reducing standard
deviation, risk, in the portfolio.
17.10 The Capital Market Line
As seen previously, adjusting for the risk of an
asset using the risk-free rate, an investor can
easily alter his risk profile. Keeping that in mind,
in the context of the capital market line (CML),
the market portfolio consists of the combination
of all risky assets and the risk-free asset, using
market value of the assets to determine the
weights. The CML line is derived by the CAPM,
solving for expected return at various levels of
risk.
Markowitz' idea of the efficient frontier, however,
did not take into account the risk-free asset. The
CML does and, as such, the frontier is extended
to the risk-free rate as illustrated below:

Answer:
The standard deviation equation for a
portfolio of two assets is rather long,
however, given the standard deviation of
the risk-free asset is zero, the equation is
simplified quite nicely. The standard
 Systematic and Unsystematic Risk
Total risk to a stock not only is a function of the
risk inherent within the stock itself, but is also a
function of the risk in the overall
market. Systematic risk is the risk associated with
the market. When analyzing the risk of an
investment, the systematic risk is the risk that
cannot be diversified away.
Unsystematic riskis the risk inherent to a stock.
This risk is the aspect of total risk that can be
diversified away when building a portfolio.
Example: CAPM model
Determine the expected return on Newco's stock
using the capital asset pricing model. Newco's
beta is 1.2. Assume the expected return on the
market is 12% and the risk-free rate is 4%.
Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%.
Using the capital asset pricing model, the
expected return on Newco's stock is 13.6%.

The Security Market Line (SML)

Similar to the CML, the SML is derived from the
ematic risk CAPM, solving for expected return. However, the
level of risk used is the Beta, the slope of the
SML.
When building a portfolio, a key concept is to
gain the greatest return with the least amount of The SML is illustrated below:
risk. However, it is important to note, that
additional return is not guaranteed for an
increased level of risk. With risk, reward can
come, but losses can be magnified as well.

17.11 The Capital Asset Pricing Model

(CAPM)

The capital asset pricing model (CAPM) is a

model that calculates expected return based on
expected rate of return on the market, the risk-
free rate and the beta coefficient of the stock.
Beta
Beta is the measure of a stock's sensitivity of
returns to changes in the market. It is a measure
of systematic risk.

e market
Example: Beta
Assume the covariance between Newco's stock
and the market is 0.001 and the variance of the
market is 0.0008. What is the beta of Newco's
stock?
Answer:
BNewco = 0.001/0.0008 = 1.25
Newco's beta is 1.25.
Determing Whether a Security is Under-,
Over- or Properly Valued
As discussed, the SML line can be derived using
CAPM, solving for the expected return using beta
as the measure of risk. Given that interpretation
and a beta value for a specific security, we can
then determine the expected return of the
security with the CAPM. Then, using the
expected return for a security derived from the
CAPM, an investor can determine whether a
security is undervalued, overvalued or properly
valued.
Example:Calculate the expected return on a
security and evaluate whether the security is
undervalued, overvalued or properly valued.
An investor anticipates Newco's security will
reach $30 by the end of one year. Newco's beta
is 1.3. Assume the return on the market is
expected to be 16% and the risk-free rate is 4%.
Calculate the expected return of Newco's stock in
one year and determine whether the stock is
undervalued, overvalued or properly valued with
a current value of $25.
Answer:
E(R)Newco = 4% + 1.3(16% - 4%) = 20%
Given the expected return of Newco's stock using
CAPM is 20% and the investor anticipates a 20%
return, the security would be properly valued.
If the expected return using the CAPM is
higher than the investor's required return,
the security is undervalued and the
investor should buy it.
If the expected return using the CAPM is
lower than the investor's required return,
the security is overvalued and should be
sold.
The Characteristic Line
The characteristic line is line that occurs when an
individual asset or portfolio is regressed to the
market. The beta is the slope coefficient for the
characteristic line and is thus the measure of
systematic risk for the asset or portfolio. Recall, a
beta is the measure of a stock's sensitivity of
returns to changes in the market. It is a measure
of systematic risk.
Portfolio
Management
What is 'Portfolio Management'
Portfolio management is the art and science of
making decisions about investment mix and
policy, matching investments to objectives, asset
allocation for individuals and institutions, and
balancing risk against performance. Portfolio
management is all about determining strengths,
weaknesses, opportunities and threats in the
choice of debt vs. equity, domestic vs.
international, growth vs. safety, and many other
trade-offs encountered in the attempt to maximize
return at a given appetite for risk.
BREAKING DOWN 'Portfolio
Management'
In the case of mutual and exchange-traded
funds (ETFs), there are two forms of portfolio
management: passive and active. Passive
management simply tracks a market index,
commonly referred to as indexing or index
investing. Active management involves a single
manager, co-managers or a team of managers
who attempt to beat the market return by actively
managing a fund's portfolio through investment
decisions based on research and decisions on
individual holdings. Closed-end funds are
generally actively managed.
The Key Elements of Portfolio
Management
Asset Allocation: The key to effective portfolio
management is the long-term mix of assets.
Asset allocation is based on the understanding
that different types of assets do not move in
concert, and some are more volatile than others.
Asset allocation seeks to optimize the risk/return
profile of an investor by investing in a mix of
assets that have low correlation to each other.
Investors with a more aggressive profile can
weight their portfolio toward more volatile
investments. Investors with a more conservative
profile can weight their portfolio toward more
stable investments.
Diversification: The only certainty in investing is it
is impossible to consistently predict the winners
and losers, so the prudent approach is to create
a basket of investments that provide broad
exposure within an asset class. Diversification is
the spreading of risk and reward within an asset
class. Because it is difficult to know which
particular subset of an asset class or sector is
likely to outperform another, diversification seeks
to capture the returns of all of the sectors over
time but with less volatility at any one time.
Proper diversification takes place across different
classes of securities, sectors of the economy and
geographical regions.
Rebalancing: This is a method used to return a
portfolio to its original target allocation at annual
intervals. It is important for retaining the asset
mix that best reflects an investors risk/return
profile. Otherwise, the movements of the markets
could expose the portfolio to greater risk or
reduced return opportunities. For example, a
portfolio that starts out with a 70% equity and
30% fixed-income allocation could, through an
extended market rally, shift to an 80/20 allocation
that exposes the portfolio to more risk than the
investor can tolerate. Rebalancing almost always
entails the sale of high-priced/low-value
securities and the redeployment of the proceeds
into low-priced/high-value or out-of-favor
securities. The annual iteration of rebalancing
enables investors to capture gains and expand
the opportunity for growth in high potential
sectors while keeping the portfolio aligned with
the investors risk/return profile.
Dynamic Asset
Allocation
Dynamic asset allocation is a portfolio
management strategy that involves rebalancing a
portfolio so as to bring the asset mix back to its
long-term target. Such rebalancing would
generally involve reducing positions in the best-
performing asset class, while adding to positions
in underperforming assets. The general premise
of dynamic asset allocation is to reduce the
fluctuation risks and achieve returns that exceed
the target benchmark.
BREAKING DOWN 'Dynamic
Asset Allocation'
For example, an investor with a $100,000
portfolio may want to hold 50% each of stocks
and bonds. After a couple of years, when stocks
have outperformed bonds, the portfolio now holds
$65,000 in stocks and $55,000 in bonds.
Assuming the investor wishes to retain the
original 50:50 asset mix, dynamic asset allocation
would result in the sale of $5,000 worth of stocks
from the portfolio, and the proceeds would be
used to buy bonds
Portfolio
Investment
A portfolio investment is a hands-off or passive
investment of securities in a portfolio, and it is
made with the expectation of earning a return.
This expected return is directly correlated with the
investment's expected risk. Portfolio investment is
distinct from direct investment, which involves
taking a sizable stake in a target company and
possibly being involved with its day-to-day
management.
BREAKING DOWN 'Portfolio
Investment'
Portfolio investments can span a wide range
of asset classes such as stocks, government
bonds, corporate bonds, Treasury bills, real
estate investment trusts (REITs), exchange-
traded funds (ETFs), mutual funds
and certificates of deposit. Portfolio investments
can also include options, derivatives such as
warrants and futures, and physical investments
such as commodities, real estate, land and
timber.
The composition of investments in a portfolio
depends on a number of factors. Some of the
most important include the investors risk
tolerance, investment horizon and amount
invested. For a young investor with limited funds,
mutual funds or exchange-traded funds may be
appropriate portfolio investments. For a high net
worth individual, portfolio investments may
include stocks, bonds, commodities and rental
properties.
Portfolio investments for the largest institutional
investors such as pension funds and sovereign
funds include a significant proportion of
infrastructure assets like bridges and toll roads.
Portfolio investments for institutional investors
generally need to have very long lives so that the
duration of their assets and liabilities match.

Impact of Risk Tolerance, Age
and Time Horizon
The investments that are made in a portfolio are
dependent on the investor's individual
circumstances. Those with a greater risk
tolerance may favor investments in stocks, real
estate, international securities and options, while
more conservative investors may opt for
government bonds and the stocks of large well-
known companies.
These risk preferences should also be weighed
against the investor's goals and time horizon. A
young person saving for retirement may have 30
years or more to save but isn't comfortable with
the risks of the stock market. This individual may
want to favor a more conservative mix of portfolio
investments despite the long time horizon.
Conversely, individuals with high risk tolerances
may want to avoid large allocations to riskier
growth stocks if they are nearing retirement age.
A progression to a portfolio of more conservative
investments is generally recommended as an
investment goal nears.
Portfolio Investments for
Retirement
Investors saving for retirement should focus on a
diversified mix of low-cost investments for their
portfolios. Index funds have become popular in
individual retirement accounts (IRAs) and 401(k)
accounts due to their broad exposure to a
number of asset classes at a minimum expense
level. These types of funds make ideal core
holdings in retirement portfolios. Those wishing to
take a more hands-on approach may tweak
portfolio allocations by adding additional asset
classes such as real estate, private equity and
individual stocks and bonds to their portfolio mix.
Aggressive
Investment
Strategy
A portfolio management strategy that attempts to
maximize returns by taking a relatively higher
degree of risk. An aggressive investment
strategy emphasizes capital appreciation as a
primary investment objective, rather than income
or safety of principal. Such a strategy would
therefore have an asset allocation with a
substantial weighting in stocks, and a much
smaller allocation to fixed income and cash.
Aggressive investment strategies are especially
suitable for young adults because their
lengthy investment horizon enables them to ride
out market fluctuations better than investors with
a short investment horizon. Regardless of the
investors age, however, a high tolerance for risk
is an absolute prerequisite for an aggressive
investment strategy.
BREAKING DOWN 'Aggressive
Investment Strategy'
The aggressiveness of an investment strategy
depends on the relative weight of high-reward,
high-risk asset classes such as equities
and commodities within the portfolio.
For example, Portfolio A which has an asset
allocation of 75% equities, 15% fixed income and
10% commodities would be considered quite
aggressive, since 85% of the portfolio is weighted
to equities and commodities. However, it would
still be less aggressive than Portfolio B, which
has an asset allocation of 85% equities and 15%
commodities.
But even within the equity component of an
aggressive portfolio, the composition
of stocks can have a significant bearing on its risk
profile. For instance, if the equity component only
comprises blue-chip stocks, it would be
considered less risky than if the portfolio only
held small-capitalization stocks. If this is the case
in the earlier example, Portfolio B could arguably
be considered less aggressive than Portfolio A,
even though it has 100% of its weight in
aggressive assets.
An aggressive strategy needs more active
management than a conservative buy-and-hold
strategy, since it is likely to be much more volatile
and would need more frequent adjustments to
tailor it to changing market conditions. More
frequent rebalancing would also be required to
bring portfolio allocations back to their target
levels, as the volatility of the assets that comprise
an aggressive portfolio will quite often lead
allocations to deviate significantly from the
original or target weights.}
Asset Allocation
Asset allocation is an investment strategy that
aims to balance risk and reward by apportioning
a portfolio's assets according to an individual's
goals, risk tolerance and investment horizon. The
three main asset classes - equities, fixed-income,
and cash and equivalents - have different levels
of risk and return, so each will behave differently
over time.
BREAKING DOWN 'Asset
Allocation'
There is no simple formula that can find the right
asset allocation for every individual. However, the
consensus among most financial professionals is
that asset allocation is one of the most important
decisions that investors make. In other words, the
selection of individual securities is secondary to
the way that assets are allocated in stocks,
bonds, and cash and equivalents, which will be
the principal determinants of your investment
results.
Investors may use different asset allocations for
different objectives. Someone who is saving for a
new car in the next year, for example, might
invest her car savings fund in a very conservative
mix of cash, certificates of deposit (CDs) and
short-term bonds. Another individual saving for
retirement that may be decades away typically
invests the majority of his individual retirement
account (IRA) in stocks, since he has a lot of time
to ride out the market's short-term fluctuations.
Risk tolerance plays a key factor as well.
Someone not comfortable investing in stocks may
put their money in a more conservative allocation
despite a long time horizon.
Age-based Asset Allocation
In general, stocks are recommended for holding
periods of five years or longer. Cash and money
market accounts are appropriate for objectives
less than a year away. Bonds fall somewhere in
between. In the past, financial advisors have
recommended subtracting an investor's age from
100 to determine how much should be invested in
stocks. For example, a 40-year old would be 60%
invested in stocks. Variations of the rule
recommend subtracting age from 110 or 120
given that the average life expectancy continues
to grow. As individuals approach retirement age,
portfolios should generally move to a more
conservative asset allocation so as to help
protect assets that have already been
accumulated.
Achieving Asset Allocation
Through Life-cycle Funds
Asset-allocation mutual funds, also known as life-
cycle, or target-date, funds, are an attempt to
provide investors with portfolio structures that
address an investor's age, risk appetite
and investment objectives with an
appropriate apportionment of asset classes.
However, critics of this approach point out that
arriving at a standardized solution for allocating
portfolio assets is problematic because individual
investors require individual solutions.
The Vanguard Target Retirement 2030 Fund
would be an example of a target-date fund. As of
2016, the fund has a 14-year time horizon until
the shareholder expects to reach retirement. As
of June 30, 2016, the fund has an allocation of
74% stocks and 26% bonds. Up until 2030, the
fund will gradually shift to a more conservative
50/50 mix, reflecting the individual's need for
more capital preservation and less risk. In
following years, the fund moves to 67% bonds
and 33% stocks.
Tactical Asset
Allocation TAA
Tactical asset allocation is an active
management portfolio strategy that shifts the
percentage of assets held in various categories
to take advantage of market pricing anomalies or
strong market sectors.
This strategy allows portfolio managers to create
extra value by taking advantage of certain
situations in the marketplace. It is as a
moderately active strategy since managers return
to the portfolio's original strategic asset mix when
desired short-term profits are achieved.
BREAKING DOWN 'Tactical
Asset Allocation - TAA'
To understand tactical asset allocation, one must
first understand strategic asset allocation. During
the process of creating an investor policy
statement (IPS), factors such as required rate of
return, acceptable risk levels, legal and liquidity
requirements, taxes, time horizon and unique
circumstances are analyzed to settle on a
strategic mix of assets to include in an investor's
portfolio. The percentage that each asset class is
weighted over the long term is known as the
strategic asset allocation. This is the mix of
assets and weights that will help an investor
reach their specific goals.
This is a simple example:
Cash = 10%
Bonds = 35%
Stocks = 45%
Commodities = 10%
The Usefulness of Tactical
Asset Allocation
Tactical asset allocation is the process of taking
an active stance on the strategic asset allocation
itself and adjusting these long-term target
weights for a short period of time to capitalize on
market or economic opportunities. For example,
assume that data suggests that there will be a
very large increase in demand for commodities
over the next 18 months. It may be prudent for an
investor to shift more capital into that asset class
to take advantage of the opportunity. While the
above portfolio's strategic allocation will remain
the same, the tactical allocation may then
become:
Cash = 5%
Bonds = 35%
Stocks = 45%
Commodities = 15%
Tactical shifts can also occur within an asset
class. Assume the 45% strategically allocated to
stocks consists of 30% large cap and 15% small
cap. If the outlook for small-cap stocks does not
look favorable, it may be a wise tactical decision
to shift the allocation within stocks to 40% large
cap and 5% small cap for a short time until
conditions change.
Usually, tactical shifts range from 5 to 10%,
though they can be lower. In practice, it is very
rare to tactically adjust any asset class by more
than 10%. This would show a fundamental
problem with the construction of the strategic
asset allocation.
Tactical asset allocation is different from
rebalancing a portfolio. During rebalancing,
trades are made to bring a portfolio back to its
desired strategic asset allocation. Tactical asset
allocation simply adjusts the strategic asset
allocation for a short time with the intention of
reverting back to the strategic allocation once the
short-term opportunities disappear.
Actively
Managed ETF
An exchange-traded fund that has a manager or
team making decisions on the underlying
portfolio allocation or otherwise not following a
passive investment strategy. An actively
managed ETF will have a benchmark index, but
managers may change sector allocations,
market-time trades or deviate from the index as
they see fit. This produces investment returns
that will not perfectly mirror the underlying index.
BREAKING DOWN 'Actively
Managed ETF '
There's no hard-and-fast rule as to whether an
actively managed fund will under- or outperform a
passive-ETF rival. Passive ETFs can at least be
counted on to follow their indexes faithfully, which
allows investors to know up front
the holdings and risk profile of the fund. This
helps to keep a diversified portfolio in line with
expectations.
Actively managed funds, however, have the
freedom to trade outside of their benchmark
indexes, which makes it more difficult for
investors to anticipate the future makeup of the returns of the equity markets. Proponents of the
portfolio. risk parity strategy state that while the 60/40
approach performs well during bull markets and

Risk Parity
periods of economic growth, it tends to fail
during bear markets and economic slumps. The
risk parity approach attempts to balance the
portfolio to perform well under a variety of
Risk parity is a portfolio allocation strategy based
economic and market conditions.
on targeting risk levels across the various
components of an investment portfolio. The Several risk parity-specific products,
risk parity approach to asset allocation allows including mutual funds, are available, and
investors to target specific levels of risk and to investors can also build their own risk parity
divide that risk equally across the entire portfolios through careful research or by working
investment portfolio in order to achieve optimal with a qualified financial professional. The first
portfolio diversification for each individual risk parity fund, the All Weather hedge fund, was
investor. Risk parity strategies are in contrast to introduced by Bridgewater Associates in 1996.
traditional allocation methods that are based on
holding a certain percentage of investment
classes, such as 60% stocks and 40% bonds,
within one's investment portfolio.
Capital Growth
BREAKING DOWN 'Risk Parity'
The risk parity approach to portfolio asset
Strategy
allocation focuses on the amount of risk in each
An asset allocation strategy that seeks to
component rather than the specific dollar
maximize capital appreciation, or the increase in
amounts invested in each component. In other
value of a portfolio or asset over the long term.
words, risk parity focuses not on the allocation of
capital (like traditional allocation models), but on
the allocation of risk. Risk parity considers four
BREAKING DOWN 'Capital
different components: equities, credit, interest Growth Strategy'
rates and commodities, and attempts to spread Portfolios with the goal of capital growth consist
risk evenly across the asset classes. The goal of mainly of equities. The exact proportion of
risk parity investing is to earn the same level of equities to the total portfolio will vary according to
return with less volatility and risk, or to realize the individual investor's investment horizon,
better returns with an equal amount of risk and financial constraints, investment goals and risk
volatility (versus traditional asset allocation tolerance.
strategies).
In general, a capital growth portfolio will contain
A traditional 60/40 portfolio can attribute 80 to
approximately 65-70% equities, 20-25% fixed-
90% of its risk allocation to equities. As a result,
income securities and the remainder in cash
the portfolio's returns will be dependent upon the
or money market securities. While seeking high
returns, this mixture still somewhat protects the
investor against a severe loss in portfolio value if
the higher-risk equity portion of the portfolio takes
a plunge.
Note that an aggressive portfolio strategy also
aims to maximize capital growth, but of the total
portfolio value, these strategies are of
considerably higher risk; sometimes consisting
entirely of equities!
Diversification
Diversification is a risk management technique
that mixes a wide variety of investments within a
portfolio. The rationale behind this technique
contends that a portfolio constructed of different
kinds of investments will, on average, yield higher
returns and pose a lower risk than any individual
investment found within the portfolio.
BREAKING DOWN
'Diversification'
Diversification strives to smooth out unsystematic
risk events in a portfolio so the positive
performance of some investments neutralizes the
negative performance of others. Therefore, the
benefits of diversification hold only if
the securities in the portfolio are not perfectly
correlated.
Studies and mathematical models have shown
that maintaining a well-diversified portfolio of 25
to 30 stocks yields the most cost-effective level of
risk reduction. Investing in more securities yields
further diversification benefits, albeit at a
drastically smaller rate.
Further diversification benefits can be gained by
investing in foreign securities because they tend
to be less closely correlated with domestic
investments. For example, an economic
downturn in the U.S. economy may not affect
Japan's economy in the same way; therefore,
having Japanese investments gives an investor a
small cushion of protection against losses due to
an American economic downturn.
Most noninstitutional investors have a limited
investment budget and may find it difficult to
create an adequately diversified portfolio. This
fact alone can explain why mutual funds have
been increasing in popularity. Buying shares in
a mutual fund can provide investors with an
inexpensive source of diversification.
Diversification and Exchange-
Traded Funds
While mutual funds provide diversification across
various asset classes, exchange-traded funds
(ETF) afford investor access to narrow markets
such as commodities and international plays that
would ordinarily be difficult to access. An
individual with a $100,000 portfolio can spread
the investment among ETFs with no overlap. If an
aggressive investor wishes to construct a
portfolio composed of Japanese equities,
Australian bonds and cotton futures, he can
purchase stakes in the iShares MSCI Japan ETF,
the Vanguard Australian Government Bond Index
ETF and the iPath Bloomberg Cotton Subindex
Total Return ETN. The specificity of the targeted
asset classes and the transparency of the
holdings ensure true diversification, with
divergent correlations among securities, can be
achieved.
Diversification and Smart Beta
Smart beta strategies offer diversification by
tracking underlying indices but do not necessarily
weigh stocks according to market cap. ETF
managers further screen equity issues on
fundamentals and rebalance portfolios according
to objective analysis and not just company size.
While smart beta portfolios are unmanaged, the
primary goal becomes outperformance of the
index itself. As of July 2016, the iShares Edge
MSCI USA Quality Factor ETF holds 125 large-
and mid-cap U.S. stocks. By focusing on return
on equity (ROE), debt-to-equity (D/E) ratio and
not solely market cap, a $10,000 investment in
the funds underlying index grew to about $10,
530 in one year ending June 2016. A similar
investment in the S&P 500 Index grew to about
$10,385.
companies with large cash flows, international vs.
domestic companies, stocks vs. bonds, etc. The
mix of these types of investments is dependent
on the clients investment needs and risk
tolerance. For instance, a manager overseeing a
portfolio for a client with low risk tolerance and a
long term investment horizon will invest in blue
chip stocks and low risk bonds such as U. S.
Treasury bonds. He will avoid stocks of
companies in developing nations and tech start-
ups.
There are two types of portfolio management with
respect to mutual funds active and passive.
Active management means that a portfolio
manager actively trades securities to try to make
a better return than the market, taking into
account the funds objectives and asset class
limitations. Most closed-end funds are actively
managed.

Portfolio Passive management refers to buying and selling

securities so that the fund assets track an index

Management
such as the S&P 500 or the NYSE.

Portfolio management is the act of maximizing What is the

the return on a portfolio. This is done with trading
decisions made for the marketable securities in
that portfolio. A portfolio manager, or a team of difference
managers, supervises the portfolio for a client.
Often, the client is the collective owners of a
mutual fund. The client can also be a wealthy between
individual who owns a large amount of
marketable securities.
portfolio
There are a number of different philosophies

management
about how to manage a portfolio. The chosen
philosophy will dictate whether the portfolio
manager invests in high growth companies,
and financial
hold the same licenses as a portfolio manager.
Individuals going through the financial planning
process often develop a plan aimed at meeting

planning?
Utilizing the expertise of a financial professional
can be beneficial to an individual wanting to
reach an investment goal or other financial
objective. However, it is important to know which
types of services are provided by the financial
professional. Although it is common to use the
terms "portfolio management" and "financial
planning" as synonyms, these staples of
the financial services industry are not the same.
Portfolio management is the act of creating and
maintaining an investment account, while
financial planning is the process of developing
financial goals and creating a plan of action to
achieve them. Understanding the difference
between the two may help in selecting the most
suitable financial professional.
Portfolio management is provided by financial
professionals who hold certain FINRA Series
licenses that allow them to create and
recommend portfolios of stocks, bonds, mutual
funds, exchange-traded funds (ETFs)
or alternative investments to meet the investment
objectives of a specific investor. Professionals
who perform portfolio management are focused
on meeting the needs of investors through
the rate of return achieved within a portfolio, and
they are often responsible for rebalancing the
account to remain in line with the investor's
allocation preferences.
short- and long-term financial objectives,
including building an emergency fund, saving for
a new home or reducing debt, accumulating
retirement assets and creating estate or tax
efficiency. Financial planning may also include a
discussion about portfolio management, but it is
focused on what rate of return needs to be
achieved to meet a specific goal or what
allocation is most appropriate for an investor's
risk appetite.
Analyzing
Investments in a
Portfolio
Framework
Clients need to know their financial advisors are
competent enough to analyze their investments
from an aggregate portfolio context. Not properly
analyzing a single investment or the portfolio as a
whole can lead to disastrous results and throw off
an entire financial plan. The following are five
items financial advisors should be specifically
looking at when analyzing an investment
portfolio.

Financial planning is a more comprehensive

process than portfolio management, although the
financial professionals that perform this task can
Correct and Specific Asset compared against should be a blended
benchmark. A portfolio consisting of more than
Categorization 10 different asset types should not be
An asset class is a group of investments with benchmarked to the S&P 500; that would be
similar risk and return characteristics. The useless. Instead, it should be benchmarked
investments are structurally the same, against a dollar-weighted blended benchmark so
experiencing similar reactions to market forces, the comparison is accurate and relevant.
laws, regulations and economics. It is very
important for a financial advisor to group Position Liquidity
individual investments into the proper categories.
In a financial plan, liquidity is a key overall
This also aids in strategic asset allocation and
concern and component. Liquidity analysis on the
tactical asset allocation analysis, which leads to
individual positions must be considered when
proper recommendations for a client's financial
making recommendations for an entire financial
plan. It is not sufficient to group stocks, mutual
plan. For example, a comprehensive financial
funds and exchange-traded funds (ETFs) into
plan for a retiree may conclude that the portfolio
such simple categories such as cash, equities
must remain liquid enough to enable a 10%
and fixed income. This is too broad of a
drawdown on the portfolio per year for living
categorization and leads to substandard analysis.
expenses. However, the client may have some
More detailed asset categorization may include
very illiquid or locked-up investments that cannot
cash, corporate fixed income, government fixed
be touched or efficiently converted to cash any
income, floating rate fixed income, international
time soon. Adjustments then have to be made
fixed income, high yield, large-cap stock, mid-cap
elsewhere. Concurrent liquidity analysis on the
stock, small-cap stock, international stock,
position level and the portfolio is crucial to a
emerging market stock, real estate, commodities
financial plan.
and alternative investments. These can even be
broken down further. More detailed categorization
Low Cost Basis Positions
leads to better asset allocation decisions.
Oftentimes, clients have very old stock and
mutual fund positions that have extremely
Correct Portfolio Benchmarking
low cost basis and thus very large capital gains.
Each individual security in the portfolio should be
Generally, it is unwise to sell these positions as
benchmarked against its relative index. For
they result in a very large tax bill. This tax bill
example, a large-cap stock mutual fund should
may not be able to be paid without using the
likely be benchmarked against the Standard and
capital from the portfolio itself, which can result in
Poor's (S&P) 500 Index. A real estate investment
dramatically lowering the value of the portfolio
trust (REIT) should likely be benchmarked
and the amount of income it produces, and can
against the Wilshire REIT Index. Improper
skew the overall asset allocation. Because of this,
benchmarking leads to bad analysis or skewed
it is important to "carve out" and isolate these
and manipulated analysis. Benchmarks should
low-cost basis positions and make investment
be 100% appropriate. Also, on an entire portfolio
decisions and recommendations around them.
level, the benchmark the portfolio's return is
The positions can be sold later in the time
horizon or gifted, providing tax benefits.
Client Choices vs. Advisor
Choices
In the financial planning business, it is quite
common to have a client be adamant about
owning a certain stock, mutual fund or other
asset. If that is the case, it is wise for the financial
advisor to analyze the investment portfolio while
isolating the asset. For example, it is a better
indicator of the advisor's skill if the portfolio
performance is analyzed as a whole, and without
the specific assets the client refuses to sell. Thus,
it can be quantitatively shown if those positions
are positively or negatively affecting the portfolio
performance, and the investment selection skill of
the advisor can also be clearly isolated.
Achieving
Optimal Asset
Allocation
Allocating your investments among different
asset classes is a key strategy to help minimize
risk and potentially increase gains. Consider it
the opposite of "putting all your eggs in one
basket."
The first step to understanding optimal asset
allocation is defining its meaning and purpose,
and then taking a closer look at how allocation
can benefit you and the right asset mix to achieve
and maintain it.
What is Asset Allocation?
Asset allocation is the strategy of dividing your
investment portfolio across various asset classes
like stocks, bonds and money market securities.
Essentially, asset allocation is an organized and
effective method of diversification.
Your options typically fall within three classes -
stocks, bonds and cash. Within these three
classes are subclasses (the variations within
each category). Some subclasses and
alternatives include:
Large-cap stock - These are shares
issued by large companies with a market
capitalization generally greater than $10
billion.
Mid-cap stock - These are issued by mid-
sized companies with a market cap
generally between $2 billion and $10
billion.
Small-cap stocks - These represent
smaller-sized companies with a market
cap of less than $2 billion. These types of
equities tend to have the highest risk due
to lower liquidity.
International securities - These types of
assets are issued by foreign companies
and listed on a foreign exchange.
International securities allow an investor to
diversify outside of his or her country, but
they also have exposure to country risk -
the risk that a country will not be able to
honor its financial commitments.
Emerging markets - This category
represents securities from the financial
markets of a developing country. Although
investments in emerging markets offer a
higher potential return, there is also higher
 risk, often due to political instability,
country risk and lower liquidity.
Fixed-income securities - The fixed-
income asset class comprises debt
securities that pay the holder a set amount
of interest, periodically or at maturity, as
well as the return of principal when the
security matures. These securities tend to
have lower volatility than equities and
lower risk because of the steady income
they provide. Note that though the issuer
promises income payment, there is a risk
of default. Fixed-income securities include
corporate and government bonds.
Money market - Money market securities
are debt securities that are extremely
liquid investments with maturities of less
than one year. Treasury bills (T-bills) make
up the majority of these types of
securities.
Real-estate investment trusts
(REITs) - Real estate investment
trusts (REITs) trade similarly to equities,
except the underlying asset is a share of a
pool of mortgages or properties, rather
than ownership of a company.
Maximizing Return &
Minimizing Risk
The main goal of allocating your assets is to
minimize risk given a certain expected level of
return. Of course to maximize return and
minimize risk, you need to know the risk-return
characteristics of the various asset classes.
Figure 1 compares the risk and potential return of
some popular choices:
Figure 1
Equities have the highest potential return, but
also the highest risk. On the other hand, Treasury
bills have the lowest risk since they are backed
by the government, but they also provide the
lowest potential return.
This is the risk-return tradeoff. Keep in mind that
high risk choices are better suited for investors
who have a high risk tolerance (can stomach
wide fluctuations in value) and who have a longer
time horizon to recover from losses.
It's because of the risk-return tradeoff - which
says that potential return rises with an increase in
risk - that diversification through asset allocation
is important. Since different assets have different
risks and market fluctuations, proper asset
allocation insulates your entire portfolio from the
ups and downs of one single class of securities.
So, while part of your portfolio may contain more
volatile securities - which you've chosen for their
potential of higher returns - the other part of your
portfolio devoted to other assets remains stable.
Because of the protection it offers, asset
allocation is the key to maximizing returns while
minimizing risk.
Deciding What's Right for You
As each asset class has varying levels of return
and risk, investors should consider their risk
tolerance, investment objectives, time horizon or an index fund, since the goal is not to beat the
and available capital as the basis for their asset market.
composition. Investors with a long time horizon
and larger sums to invest may feel more
comfortable with high risk, high return options.
Contrastingly, investors with smaller sums and
shorter time spans may feel more comfortable
with low risk, low return allocations.

To make the asset allocation process easier for

clients, many investment companies create a
series of model portfolios, each comprising
different proportions of asset classes. These
portfolios of different proportions satisfy a
particular level of investor risk tolerance. In
general, these model portfolios range
from conservative to very aggressive:
Moderately Conservative
Portfolios
A moderately conservative portfolio is ideal for
those who wish to preserve a large portion of the
portfolio's total value, but are willing to take on a
higher amount of risk to get some inflation
protection. A common strategy within this risk
level is called "current income." With this strategy,
you chose securities that pay a high level
of dividends or coupon payments.

Conservative Portfolios
Conservative model portfolios generally allocate
a large percent of the total portfolio to lower-risk
securities such as fixed-income and money
market securities. The main goal of a
conservative portfolio is to protect the principal
value of your portfolio (the money you originally
Moderately Aggressive
invested). As such, these models are often Portfolios
referred to as "capital preservation portfolios". Moderately aggressive model portfolios are often
referred to as "balanced portfolios" since the
Even if you are very conservative and prefer to
asset composition is divided almost equally
avoid the stock market entirely, some exposure
between fixed-income securities and equities in
can help offset inflation. You could invest the
order to provide a balance of growth and income.
equity portion in high-quality blue chip companies
Since moderately aggressive portfolios have a
higher level of risk than conservative portfolios,
this strategy is best for investors with a longer
time horizon (generally more than five years),
and a medium level of risk tolerance.
Aggressive Portfolios
Aggressive portfolios mainly consist of equities,
so their value tends to fluctuate widely. If you
have an aggressive portfolio, your main goal is to
obtain long-term growth of capital. As such, the
strategy of an aggressive portfolio is often called
a "capital growth" strategy. To provide some
diversification, investors with aggressive
portfolios usually add some fixed-income
securities.
Very Aggressive Portfolios
Very aggressive portfolios consist almost entirely
of equities. As such, with a very aggressive
portfolio, your main goal is aggressive capital
growth over a long time horizon. Since these
portfolios carry a considerable amount of risk, the
value of the portfolio will vary widely in the short
term.
Tailor Your Allocations to Your
Needs
Note that the above outline of model portfolios
and the associated strategies offer only a loose
guideline - you can modify the proportions to suit
your own individual investment needs. How you
fine tune the models above can depend on your
future needs for capital and what kind of investor
you are.
For instance, if you like to research your own
companies and devote time to stock picking, you
will likely further divide the equities portion of
your portfolio among subclasses of stocks. By
doing so, you can achieve a specialized risk-
return potential even further within one portion of
your portfolio.
Also, the amount of cash and equivalents or
money market instruments you place in your
portfolio will depend on the amount of liquidity
and safety you need. If you need investments
that can be liquidated quickly or you would like to
maintain the current value of your portfolio, you
might consider putting a larger portion of your
investment portfolio in money market or short-
term fixed-income securities. Those investors
who do not have liquidity concerns and have a
higher risk tolerance will have a small portion of
their portfolio within these instruments.
Asset Allocation Strategies
While you decide how to allocate your portfolio,
keep in mind several allocation strategies and
their goals. Each one offers a different approach
based on the investor's time frame, goals and risk
tolerance. The most common strategies include
strategic, tactical, constant weighting and
systemic asset allocation.
The Importance of Maintaining
Your Allocated Portfolio
Once you have chosen your portfolio investment
strategy, it's important to conduct periodic
portfolio reviews, as the value of various assets
will change. This affects the weighting of each
asset class, meaning over time a portfolio can
grow from containing primarily one type of asset
class to another. For example, if you start with a
moderately conservative portfolio, the value of
the equity portion may increase significantly
during the year, suddenly giving you an equity
heavy portfolio. This makes the portfolio more
like that of an investor practicing a balanced
portfolio strategy, which is higher risk!
In order to reset your portfolio back to its original
state, you need to rebalance your portfolio.
Rebalancing is the process of selling portions of
your portfolio that have increased significantly
and using those funds to purchase additional
units of assets that have declined slightly or
increased at a lesser rate. This process is also
important if your investment strategy or tolerance
for risk has changed.
The Bottom Line
Asset allocation is a fundamental investing
principle because it helps investors maximize
profits while minimizing risk. The different asset
allocation strategies described above cover a
wide range of investment styles, accommodating
varying risk tolerance, time frames and goals.
Once you've chosen an appropriate asset
allocation strategy, remember to conduct periodic
reviews of your portfolio to ensure you're
maintaining your intended allocation and are still
on track to your long-term investment goals.
A Guide to DIY
Portfolio
Management
Do you know why men don't ask for directions?
Because we don't. Building a travel itinerary can
seem like a mundane and unnecessary task in
preparation for a long journey but a contingency
plan might help get you back on track should you
lose your way. Getting lost because of poor
navigation could cost you more than an hour of
driving.
Similarly, in the case of your investment portfolio,
making a wrong turn could cost you years of
appreciation. Preparation precipitates good
fortune. In my experience, some of the worst
portfolios I've seen are those created by the do-it-
yourselfers. There have been some whoppers:
disconnected investments, liquidity issues, too
little risk, too much risk, improperly titled
accounts, unnecessary tax liability and finally
"investments" that are not registered securities.
(For more, see: Achieving Optimal Asset
Allocation.)
It shouldn't surprise you that these are educated
people too, some of them highly so. Knowing
which direction to travel into the water does not
make you an expert swimmer. It simply means
the further you travel in that direction the stronger
swimmer you'll need to be to find your way back.
What many DIY-ers fail to recognize are some of
the principles surrounding comprehensive
portfolio creation. Let's look at some of the pillars
before you begin raising the investment roof.
Before You Start
1) Purpose Your Money: If you're like most of
us, money has a purpose such as retirement,
college, new home purchase, etc. Be specific.
What are you using this money for and how much
will you need? When will you need to use this
money?
2) Suitable Risk: What type of risk you put on
this money will likely be directly proportionate to
the expected return. Wherever you invest money,
there is a chance you could lose money. What is
an acceptable level of risk for you as an investor?
Does your acceptable level of risk correspond to
your purpose and expected return for this
money? (For more, see: Five Things to Know
About Asset Allocation.)
3) Tax Treatment: Don't be surprised, the
government will take their share. "That's my
money. I don't have to pay taxes on it."
The Internal Revenue Service (IRS) says you do.
As a professional, I've actually had that
conversation more times than I'd like to admit.
Taxes cannot be avoided but an investor should
know how to properly navigate the tax treatment
of their investments.
4) Properly Titling Accounts: How an account
is titled can drastically affect how the money will
be used later and passed to another in the event
of your untimely departure from the DIY-er realm
of investors. Make a mistake here and it could
cost you tens of thousands of dollars. Once an
account is titled you'll not get any sympathy in
this industry if you've made a mistake. (For more,
see: Diversification: Protecting Portfolios from
Mass Destruction.)
That's a good beginning to our structure and
necessary in determining a direction for any
investor. You'll need a backbone to your
investment structure. Then, once you've
purposed and defined your investments, you'll be
ready to start deciding on how to allocate your
investment choices. How you allocate your profile
depends on your comfort level with certain types
of investment products. You'll have many asset
classes to choose from. It may be helpful to
select the products in which you have the most
understanding. Modern Portfolio Theory is one
tool most investors have when it comes to
understanding risk/return and portfolio
construction and whether to adopt a 90/10
aggressive portfolio, 80/20 or 70/30 growth
portfolio, 60/40 moderate growth portfolio or a
20/70/10 conservative (stocks/bonds/cash)
portfolio. This basic approach is a principled one
and could serve you well.
Diversification Above All
Proper diversification is something you'll want to
consider when selecting investments.
Investments are broken down into categories like
size, style, and foreign or domestic.
Understanding the corresponding risk level with
each investment will be important when selecting
the percent composition for your portfolio. For
instance, a 45% allocation to foreign small-
cap growth stocks might not be a bad place to be
but that might not be true for someone who is
purposing this money to be used in the next
three-to-five years. (For more, see: The
Importance of Diversification.)
Consider Current Conditions
Current economic conditions could impact your
portfolio composition in sharp contrast to a
traditionally-styled portfolio. Let's consider rising
rates. Mid- to long-term bonds have typically
been a safe place for the last three decades. But
that might not be true for an investor who is two
years from retirement and is currently allocated
60% to mid- to long-term bonds in a rising
interest rate environment.
Stay the Course
DIY-ers will have to manage the fear mongering
that has become so commonplace with our major
market news channels. Trading during volatile
times created by current events like what we've
experienced around the world as of late could be
a huge detriment to your portfolio. Moving money
in and out of the market frequently is ill advised.
Make some rules for your investment approach
and don't deviate from that principled,
unemotional approach. Yes, it's easier said than
done - even for professionals. (For more,
see: Portfolio Management Pays Off in a Tough
Market.)
Stick to Your Process
Put a plan in place and stick to it. Create
contingencies in the event things get
unmanageable. Consider sound independent
research and I don't mean from your television. If
you do, you'll likely be disappointed. Most TV
spots are for ratings and fear mongering, not for
comprehensive investment advice. Spending
some of your hard earned money for some
investment advice from a bona fide research firm
may help to tilt the odds in your favor. Create a
rules-based approach to managing investments.
When to buy, when to sell, desired returns and
acceptable losses are some categories to
consider.
Always Continue Learning
Educate yourself on the industry. Research topics
that interest you. Nothing beats passion when it
comes to spending time caring for your
investment portfolio. Never do anything you're not
comfortable with. There are so many places to
get information. (For more, see: A Guide to
Portfolio Construction.)
The Bottom Line
Start with your foundational pillars and purpose
your money. Get your investor ID. Who are you
as an investor? Make a road map. Stay abreast
of the changes to our economy. You just might
learn how to take advantage of the information
you're filtering. As always, don't let yourself be
bogged down. If it gets to be too much, consult a
professional. Don't be surprised if they don't work
for free when you ask for advice. (For more,
see: Asset Allocation Strategies.)
The opinions voiced in this material are for
general information only and are not intended to
provide specific advice or recommendations for
any individual. Bonds are subject to market and
interest rate risk if sold prior to maturity. Bond
values will decline as interest rates rise and
bonds are subject to availability and change in
price.
The economic forecasts set forth in the
presentation may not develop as predicted and
there can be no guarantee that strategies
promoted will be successful. There is no
guarantee that a diversified portfolio will enhance
overall returns or outperform a non-diversified
portfolio. Diversification does not protect against
market risk. Asset allocation does not ensure a
profit or protect against a loss. Past performance
is no guarantee of future results.
A Strategy For
Optimal Stock
And Bond
Allocation
One of the most difficult elements of investing is
to know when to get in and out of specific
markets. However, a buy and hold strategy has
never been optimal, and even less so in recent
years. Thus, two key questions have to be
answered: How can one avoid a major downturn
and improve performance? And how can one
ensure that, to the greatest possible extent, one
is optimally invested in the best asset classes?
One way of doing this is to restrict oneself to
stocks and bonds and use a proven and effective
strategy known as the "best of two."
SEE: 3 Ways To Increase Your Investment
Performance
How the Strategy Works
The basic idea is to use past trends to determine
a sound investment balance for the future.
However, this does not mean trying to predict the
future from the past. Indeed, it is just the
opposite. The allocation to stocks and bonds
works according to fixed mathematical rules and
criteria without "active management" in the usual
sense. There is no stock picking, with the stocks
and bonds being held in the form
of index investments such as exchanged-traded
funds. Given the dangers of stock picking and of
trying to predict the markets, this is a sound basis
for a strategy.
At the start of each calendar year, there is a
50/50 allocation which is reviewed monthly and
adjusted as necessary. The aim is to
systematically overweight the better performing
asset class and vice versa. If the stocks are
performing badly, they will be underweighted and
bonds overweighted. Of particular importance is
the fact that within a given year, the allocation to
one of the classes can rise to 100% or fall to
zero. The portfolio is always fully invested, such
that the stock and bond proportions total 100% at
any point in time.
More on the Mechanics
Option price theory is used to calculate how to
allocate the funds to the two asset classes.
Because no suitable and standardized options
are available and OTC ones have some serious
disadvantages, a replication is used. This
enables an investment in the two asset classes in
the right proportions. Monte Carlo
simulations have also indicated that a monthly
adjustment is sufficient. The full details are too
complex to be explained here.
SEE: Cut Down Option Risk With Covered Calls
Who Should Go for the Best of Two?
The strategy is ideal for people who like the idea
of relying on a fixed formula, says Dr. Ulrich
Stephan, the chief investment strategist of the
Deutsche Bank in Germany. Naturally, the
strategy won't perform as well as a pure equity
investment in a bull market, but in a bear market,
there is a fair amount of protection. Furthermore,
the strategy generally works better over time than
a rigid equity-bond allocation. Also, it is
straightforward in that it just has stocks and
bonds, both of which work in terms of indexes. So
it is appealing for those who like simplicity.
From a time perspective, at least five years is
recommended, so that the strategy can maximize
its potential over various market phases.
The Risks
The strategy is certainly not risk-free, particularly
if both asset classes do badly at the same time.
However, there is nothing to stop investors from
having other investments too (above and beyond
the best of two), such as real estate or
infrastructure. Additionally, the best of two can be
global; it does not have to focus only on the
United States or Germany, for instance.
SEE: Straddle Strategy A Simple Approach To
Market Neutral
The Results
Hubert Dichtl and Christian Schlenger, from the
German consulting company Alpha Portfolio
Advisors, evaluated the performance of the
strategy over a 30-year period and found that it
beat the equity markets over time and
considerably reduced volatility. Furthermore, the
performance beats a constant 50/50 allocation
between stocks and bonds. It is thus a better bet
than mixed funds working with such fixed
proportions.
The best of two clearly enables a sustainable
participation in positive stock market
developments, and provides good protection
against major declines and crashes. It should be
noted that the strategy has more of a total return
than an absolute return character through the
blend of stocks and bonds with an index basis.
Using the Strategy for Institutional
Investments
Given the proven performance potential and the
high level of flexibility of the best of two strategy,
it is well suited to managing funds. For example,
it could be used to switch between a Dow Jones
tracker and the Merrill Lynch Domestic Master.
This facilitates a systematic and professional
stock/bond exposure over time. The right
integration of strategic and dynamic asset
allocation can be achieved, and that is no mean
feat.
The Bottom Line
The best of two method facilitates a retrospective
switching between two asset classes, namely
stocks and bonds. The application of
derivatives in the form of exchange option
enables one to avoid poorly performing markets
and to be there for the good times. It does not
achieve this with complete perfection or in all
situations, but it does a fine job over time. Who
could ask for more than that?
3 Ways To
Increase Your
Investment
Performance
Although buy low and sell high is a strategy that
has resulted in big accumulations of wealth, this
isn't how the professionals find their success.
Instead, a savvy investor strategically deploys
their money, in order to allow it to work in more
than one way; they multitask their money.
TUTORIAL: Investing 101
The retail investor who is accustomed to working
with stocks can simultaneously put their money to
work in three ways:
Price Action - The stock will hopefully rise
in value
Dividend - The fee a company pays you in
exchange for using your money.
Call Revenue - The money an investor
pays you when you sell a covered
call against your stock.
Price Action
If investing were a game, the way you'd win
would be to buy a stock at a low price and sell it
at a higher price, on a later date. If you own a
home, you understand this concept in a very
practical way.
In order to make a profit on your investment, it's
often best to use one of two strategies to do that.
The first is called value investing. Stocks, just like
the products you purchase every day, go on sale
from time to time and value investors wait for that
sale price. This makes it even easier to make a
profit, because stocks that are undervalued (on
sale) have more room to grow. (Learn how to
value invest, read 5 Must-Have Metrics For Value
Investors. and The Value Investor's Handbook.)
The second way is momentum trading. Some
investors believe that the best time to buy a stock
is when it continues to go higher, because just as
we learned in grade school, an object in motion
tends to stay in motion. The problem
with momentum trading is that it tends to work
better for shorter-term investors. For our strategy,
we want to think long term. The more years you
hold the stock, the better your potential returns
could be.
How to Pick Your Stock
Your favorite stock may not work for this strategy,
because it must pay a dividend, it must have a
price that is cheap enough that you can purchase
100 shares, and it must trade a lot of shares each
day; at least 1 million shares of daily volume is
best. Remember that a company's value is not
based on its price. There are a lot of high quality
stocks that are under $30 per share and there
are a lot of low quality stocks that trade above
$100. I have found that stocks between $15 and
$30, with at least a 2% dividend yield, are ideal.
Finally, you don't want a highly volatile stock. If it
has wild price swings, that will be much tougher
to manage.
This is where you put your stock research and
evaluation skills to work. Once you find your
stock, assuming that you want to value invest,
look for this name to be in the middle, or towards
the bottom, of the trading range for the past 52
weeks. If it isn't there now, either wait for it to give
you a price that you want, or find another
company. There are plenty of worthy candidates
for this strategy. (Learn more in Enter Profitable
Territory With Average True Range.)
Dividend
In a high-tech stock trading world, investing for a
dividend might be considered boring, but
dividends can be a big income source for the
long-term investor. Between 1929 and 1990, 40%
of all stock market gains were a result of that
boring, quiet dividend, according to the research
report "High Yield, Low Payout" by Credit Suisse.
The dividend gives us two advantages that help
our money work for us in more than one way.
Firstly, it gives us a stable income. Sure, a
company can choose to pay or not pay a
dividend, as they would like, but for a high quality
company, with a low payout ratio, there is a lower
chance of the dividend on a quarterly payment
getting cut. Secondly, it lowers your cost basis for
the stock you purchased.
Let's assume that you did your research and
decided on stock XYZ. You bought 100 shares
for $30 per share, which at the time had a
3% dividend yield.
$3,000 x 3% = $90 each year. Not only are you
making $90 each year, but since a dividend is
paid to you in cash into your account (most of the
time), each year that you own your 100 shares,
you can apply that dividend payment to what you
paid for the stock and, in this case, subtract 90
cents per share. After just five years, your stock
that cost you $30 per share, goes down to $25.50
per share. Many long-term investors reduce the
price they paid for a stock to $0, just from the
dividend. (Learn more about this in How do I
figure out my cost basis on a stock investment?)
Covered Call
Covered calls are a little more complicated. If you
don't feel confident with this leg of the strategy,
buying a stock and collecting the dividend as it
goes higher will still be an impressive gain. (If you
don't know how a covered call works, read about
them here: The Basics of Covered Call.)
Before we sell the covered call we have to make
two important decisions:
What is the strike price?
How many months into the future do we
want our contract to expire?
Strike Price
A covered call is an options contract strategy that
gives the holder of the contract the right to
purchase your 100 shares, if it is at or above the
strike price. Presumably, you don't want your
shares taken from you, although you may change
your mind in later years, so your strike price
needs to be high enough that the stock doesn't
rise above the strike price, but low enough that
you can still collect a healthy premium for the risk
you're taking.
This decision is tough. If your stock is in
a downtrend, you can probably sell an option with
a strike that isn't much higher than the
stock's current price. If the stock is in an uptrend,
for the sake of safety, consider waiting to sell the
call, until you believe the move up has run its
course, and the stock will soon go the other way.
Remember, when the stock rises in value, the
value of your option falls. This also adds the
benefit of the covered call acting as a hedge. (For
more advanced reading on these types of
strategies, check out An Alternative Covered Call
Options Trading Strategy.)
Expiration Date
The further into the future you take your option,
the more of a premium you will be paid upfront, to
sell the call, but that's also more time that your
stock has to stay below the strike price, to avoid
having it "called away" from you. For your first
contract, consider going three months into the
future.
The covered call will make money for you as
soon as you sell it, because the premium that the
buyer paid is deposited directly in to your
account. It will continue to make money for you if
the price of your stock falls. As the price falls, so
does the premium. You can purchase the
contract back from the buyer at any time, so if the
premium falls, you can purchase it for less than
you sold it. That equals profit. On the other hand,
if the stock rises above the strike price, you can
purchase the contract for more than you sold it
and incur a loss, but it saves you from having to
give up your 100 shares.
One of the best ways to use the covered call is
for the collection of the premium at the beginning,
and although you can buy the option back if it
goes up or down, save this for severe
circumstances. Also remember that the money
you collect by selling your covered call can also
be subtracted from the price you paid for the
stock (For more, check out Cut Down Option
Risk With Covered Calls.)
Go Virtual
The best way to learn a complicated investing
strategy, like the covered call, is by using a virtual
platform where you don't have to worry about
losing real money. You can still purchase the
stock and collect the dividend, but wait to sell the
covered call until you're comfortable with how it
works.
The Bottom Line
For most investors, putting money in high quality
stocks for long periods of time, while harnessing
dividend income, is the best way to make money
in the market. Later, once you understand how to
use the covered call, you can significantly
increase your yield. Although the fixed
income side of investing isn't as thrilling to watch,
it is the most appropriate for retail investors and
as we can see, the numbers can add up fast.
Cut Down
Option Risk
With Covered
Calls
The covered call strategy is an excellent strategy
that is often employed by both experienced
traders and traders new to options. Because it is
a limited risk strategy, it is often used in lieu of
writing calls "naked" and, therefore, brokerage
firms do not place as many restrictions on the
use of this strategy. You will need to be approved
for options by your broker prior to using this
strategy, and it is likely that you will need to be
specifically approved for covered calls. Read on
as we cover this option strategy and show you
how you can use it to your advantage.
SEE: Options Basics
Options Basics
For those who are new to options, let's review
some basic options terminology. A call
option gives the buyer the right, but not the
obligation, to buy the underlying instrument (in
this case, a stock) at a predetermined price
(the strike price) on or before a predetermined
date (option expiration). For example, if you buy
July 40 XYZ calls, you have the right, but not the
obligation, to buy XYZ at $40 per share any time
between now and the July expiration. This type of
option can be very valuable in the event of a
significant move above $40. Each option contract
you buy is for 100 shares. The amount the trader
pays for the option is called the premium.
There are two values to the option,
the intrinsic and extrinsic value, or time premium.
The intrinsic value is also referred to as the
option's moneyness. Using our XYZ example, if
the stock is trading at $45, our July 40 calls have
$5 of intrinsic value. If the calls are trading at $6,
that extra dollar is the time premium. If the stock
is trading at $38 and our option is trading at $2,
the option only has a time premium and is said to
be out of the money.
It is often said that professionals sell options and
amateurs buy them. This is not true 100% of the
time, but it is certainly true that professional
option traders know when it is appropriate to
employ a given strategy. Option sellers write the
option in exchange for receiving the premium
from the option buyer. They are expecting the
option to expire worthless and, therefore, keep
the premium. For some traders, the disadvantage
of writing options naked is the unlimited risk.
When you are an option buyer, your risk is limited
to the premium you paid for the option. But when
you are a seller, you assume unlimited risk.
Refer back to our XYZ example. The seller of that
option has given the buyer the right to buy XYZ at
40. If the stock goes to 50 and the buyer
exercises the option, the option seller will be
selling XYZ at $40. If the seller does not own the
underlying stock, he or she will have to buy it on
the open market for $50 to sell it at $40. Clearly,
the more the stock's price increases, the greater
the risk for the seller.
How Can a Covered Call Help?
In the covered call strategy, we are going to
assume the role of the option seller. However, we
are not going to assume unlimited risk because
we will already own the underlying stock. This
gives rise to the term "covered" call--you are
covered against unlimited losses in the event that
the option goes in the money and is exercised.
The covered call strategy is twofold. First, you
already own the stock. It needn't be in 100 share
blocks, but it will need to be at least 100 shares.
You will then sell, or write, one call option for
each multiple of 100 shares (i.e., 100 shares = 1
call, 200 shares = 2 calls, 276 shares = 2 calls).
When using the covered call strategy, you have
slightly different risk considerations than you do if
you own the stock outright. You do get to keep
the premium you receive when you sell the
option, but if the stock goes above the strike
price, you have capped the amount you can
make. If the stock goes lower, you are not able to
simply sell the stock; you will need to buy back
the option as well.
When to Use a Covered Call
There are a number of reasons traders employ
covered calls. The most obvious is to produce
income on stock that is already in your portfolio.
Others like the idea of profiting from option
premium time decay, but do not like the unlimited
risk of writing options uncovered.
A good use of this strategy is for a stock that you
might be holding and that you want to keep as a
long-term hold, possibly for tax or dividend
purposes. You feel that in the current market
environment, the stock value is not likely to
appreciate, or it might drop some. As a result,
you may decide to write covered calls against
your existing position.
Alternatively, many traders look for opportunities
on options they feel are overvalued and will offer
a good return. To enter a covered call position on
a stock you do not own, you should
simultaneously buy the stock and sell the call.
Remember when doing this that the stock may go
down in value. In order to exit the position
entirely, you would need to buy back the option
and sell the stock.
What to Do at Expiration
Eventually, we will reach expiration day. What do
you do then?
If the option is still out of the money, it is likely
that it will just expire worthless and not be
exercised. In this case, you don't need to do
anything. If you still want to hold the position, you
could "roll out" and write another option against
your stock further out in time. Although there is
the possibility that an out of the money option will
be exercised, this is extremely rare.
If the option is in the money, you can expect the
option to be exercised. Depending on your
brokerage firm, it is very possible that you don't
need to worry about this; everything will be
automatic when the stock is called away. What
you do need to be aware of, however, is what, if
any, fees will be charged in this situation. You will
need to be aware of this so that you can plan
appropriately when determining whether writing a
given covered call will be profitable.
Let's look at a brief example. Suppose that you
buy 100 shares of XYZ at $38 and sell the July
40 calls for $1. In this case, you would bring in
$100 in premiums for the option you sold. This
would make your cost basis on the stock $37
($38 paid per share - $1 for the option). If the July
expiration arrives and the stock is trading at or
below $40 per share, it is very likely that the
option will simply expire worthless and you will
keep the premium (in cash). You can then
continue to hold the stock and write another
option for the next month if you choose.
If, however, the stock is trading at $41, you can
expect the stock to be called away. You will be
selling it at $40 - the option's strike price. But
remember, you brought in $1 in premium for the
option, so your profit on the trade will be $3
(bought the stock for $38, received $1 for the
option, stock called away at $40). Likewise, if you
had bought the stock and not sold the option,
your profit in this example would be the same $3
(bought at $38, sold at $41). If the stock was
higher than $41, the trader that held the stock
and did not write the 40 call would be gaining
more, whereas for the trader who wrote the 40
covered call the profits would be capped.
The Bottom Line
The covered call strategy works best for the
stocks for which you do not expect a lot
of upside or downside. Essentially, you want your
stock to stay consistent as you collect the
premiums and lower your average cost every
month. Also, always remember to account for
trading costs in your calculations and possible
scenarios.
Like any strategy, covered call writing has
advantages and disadvantages. If used with the
right stock, covered calls can be a great way to
reduce your average cost.
What ETF Fund
Managers Do
A number of factors go into determining the
typical daily activities and job responsibilities for
an ETF portfolio manager. Among these factors
are such things as the basic type of fund being
managed, whether it is an actively managed
ETF or one that engages in passive index
investing, and how large a support staff the fund
manager has to assist in evaluating investments
and handling customer service tasks. The
activities of ETF portfolio managers fall into one
of two categories: activities related to making
investment decisions for the fund and activities
involved in client/customer relations.
Investment Management
The primary job responsibility of an ETF portfolio
manager is handling portfolio investments. The
portfolio manager is ultimately responsible for
making the decisions on investments to include in
the fund's portfolio. An ETF manager engages in
ongoing research and equity or other asset
evaluation, keeping track of market activity and
trends, and monitoring economic news and
conditions that may affect the portfolio's
profitability. Risk assessment is one essential
element of portfolio management, especially
when substantial changes to the portfolio's
holdings are being considered.
The task of making investment choices is
considerably greater with an actively managed
ETF as opposed to one that follows an index.
Passive index funds usually make substantial
changes to the portfolio only when the index is
periodically rebalanced. However, even managing
index funds requires regular investment
assessment. It is common for index funds to
commit a portion of assets to investments not
contained in the underlying index. The portfolio
manager makes those supplemental investment
choices. An index ETF manager periodically
evaluates whether the underlying index is the
best choice to achieve the fund's investment
goals.
In making investment decisions, a portfolio
manager is typically assisted by a team of
researchers, market analysts and traders. Team
meetings are held in which analysts or
researchers assigned to cover specified portions
of the portfolio make reports and offer opinions
regarding existing or proposed portfolio holdings. Customer service is one area where job
The portfolio manager may also regularly contact responsibilities differ depending on the individual
other analysts, outside of the fund's team, for portfolio manager and asset management firm. A
information on prospective investments. In order superstar portfolio manager at BlackRock Inc.
to assess equity investments accurately, ETF (NYSE: BLK), for example, may not be expected
managers do not simply rely on analyzing to personally handle the same level of marketing
financial statements but also commonly meet and customer service work as a relatively
with corporate executives to make informed unknown fund manager at a smaller firm. Larger
decisions on investing in a company's stock. asset management firms have larger auxiliary
and support staff to handle sales and marketing
Client Relations work and customer service inquiries.
The largest investors in virtually any ETF are
institutional investors, such as banks or pension ETF Managers vs. Mutual Fund
funds. Since they account for a large proportion Managers
of an ETF's total assets under
The jobs of ETF portfolio managers and mutual
management (AUM), and a correspondingly large
fund portfolio managers are often essentially
proportion of the fees the ETF generates, it is
interchangeable except in regard to one of the
critically important to attract and maintain such
major differences between ETFs and mutual
investors. Therefore, an important responsibility
funds. Shares of ETFs are freely traded on
of an ETF portfolio manager is to meet with
exchanges throughout the trading day, bought
prospective institutional investors and persuade
and sold by shareholders. In contrast, mutual
them to invest in the fund. After securing
fund shares are directly purchased from, and sold
investments, the portfolio manager continues to
to, the fund issuer, with transactions only done
meet with investors periodically to ensure their
once daily, at the closing price.
continued investment in the fund and to possibly
secure additional investment capital. An ETF portfolio manager is not burdened with
handling actual transactions for shares. A mutual
In addition to working with institutional clients,
fund manager, however, has to handle share
there is also the day-to-day work of handling
redemptions directly when shareholders wish to
customer service issues of any investor in the
sell shares. Large share redemptions usually
fund. That kind of work is typically handled by
require liquidating some of the fund's holdings to
customer service personnel rather than directly
handle the redemption, and the fund manager
by a portfolio manager. However, a fund manager
still has to address general customer service
issues, such as writing regular reports on the
fund and informing clients of new services offered
to investors or upgrades of the company's trading
Money Vs.
platform.
Time-Weighted
Return
Money-weighted and time-weighted rates of
return are two methods of measuring
performance, or the rate of return on an
investment portfolio. Each of these two
approaches has particular instances where it is
the preferred method. Given the priority in today's
environment on performance returns (particularly
when comparing and evaluating money
managers), the CFA exam will be certain to test
whether a candidate understands each
methodology.
Money-Weighted Rate of Return
A money-weighted rate of return is identical in
concept to an internal rate of return: it is the
discount rate on which the NPV = 0 or the
present value of inflows = present value of
outflows. Recall that for the IRR method, we start
by identifying all cash inflows and outflows. When
applied to an investment portfolio:
Outflows
1. The cost of any investment purchased
2. Reinvested dividends or interest
3. Withdrawals
Inflows
1.The proceeds from any investment sold
2.Dividends or interest received
3.Contributions
Example:
Each inflow or outflow must be discounted back
to the present using a rate (r) that will make PV
(inflows) = PV (outflows). For example, take a
case where we buy one share of a stock for $50
that pays an annual $2 dividend, and sell it after
two years for $65. Our money-weighted rate of
return will be a rate that satisfies the following
equation:
PV Outflows = PV Inflows = $2/(1 + r) + $2/(1 +
r)2 + $65/(1 + r)2 = $50
Solving for r using a spreadsheet or financial
calculator, we have a money-weighted rate of
return = 17.78%.
Exam Tips and Tricks
Note that the exam will test knowledge of
the concept of money-weighted return,
but any computations should not require
use of a financial calculator
It's important to understand the main limitation of
the money-weighted return as a tool for
evaluating managers. As defined earlier, the
money-weighted rate of return factors all cash
flows, including contributions and withdrawals.
Assuming a money-weighted return is calculated
over many periods, the formula will tend to place
a greater weight on the performance in periods
when the account size is highest (hence the label
money-weighted).
In practice, if a manager's best years occur when
an account is small, and then (after the client
deposits more funds) market conditions become
more unfavorable, the money-weighted measure
doesn't treat the manager fairly. Here it is put
another way: say the account has annual
withdrawals to provide a retiree with income, and
the manager does relatively poorly in the early
years (when the account is larger), but improves
in later periods after distributions have reduced
the account's size. Should the manager be
penalized for something beyond his or her
control? Deposits and withdrawals are usually
outside of a manager's control; thus, a better
performance measurement tool is needed to
judge a manager more fairly and allow for
comparisons with peers - a measurement tool
that will isolate the investment actions, and not
penalize for deposit/withdrawal activity.
Time-Weighted Rate of Return
The time-weighted rate of return is the preferred
industry standard as it is not sensitive to
contributions or withdrawals. It is defined as the
compounded growth rate of $1 over the period
being measured. The time-weighted formula is
essentially a geometric mean of a number of
holding-period returns that are linked together or
compounded over time (thus, time-weighted).
The holding-period return, or HPR, (rate of return
for one period) is computed using this formula:
Formula 2.8
HPR = ((MV1 - MV0 + D1 - CF1)/MV0)
(b) multiplying all 1 + HPR terms together, then
(c) subtracting 1 from the product:
Compounded time-weighted rate of return, for N
holding periods
= [(1 + HPR1)*(1 + HPR2)*(1 + HPR3) ... *(1 +
HPRN)] - 1.
The annualized rate of return takes the
compounded time-weighted rate and
standardizes it by computing a geometric
average of the linked holding-period returns.
Formula 2.9
Annualized rate of return = (1 +
compounded rate)1/Y - 1
Where: Y = total time in years
Example: Time-Weighted Portfolio Return
Consider the following example: A portfolio was
priced at the following values for the quarter-end
dates indicated:

Where: MV0 = beginning market value, MV1 = Date Market Value

ending market value,
D1 = dividend/interest inflows, CF1 = cash flow Dec. 31, 2003 $200,000
received at period end (deposits subtracted,
withdrawals added back) March 31, 2004 $196,500

June 30, 2004 $200,000

For time-weighted performance measurement,
the total period to be measured is broken into Sept. 30, 2004 $243,000
many sub-periods, with a sub-period ending (and
portfolio priced) on any day with significant Dec. 31, 2004 $250,000
contribution or withdrawal activity, or at the end of
On Dec. 31, 2004, the annual fee of $2,000 was
the month or quarter. Sub-periods can cover any
deducted from the account. On July 30, 2004, the
length of time chosen by the manager and need
annual contribution of $20,000 was received,
not be uniform. A holding-period return is
which boosted the account value to $222,000 on
computed using the above formula for all sub-
July 30. How would we calculate a time-weighted
periods. Linking (or compounding) HPRs is done
rate of return for 2004?
by
(a) adding 1 to each sub-period HPR, then
Answer:
For this example, the year is broken into four
holding-period returns to be calculated for each
quarter. Also, since a significant contribution of
$20,000 was received intra-period, we will need
to calculate two holding-period returns for the
third quarter, June 30, 2004, to July 30, 2004,
and July 30, 2004, to Sept 30, 2004. In total,
there are five HPRs that must be computed using
the formula HPR = (MV1 - MV0 + D1 - CF1)/MV0.
Note that since D1, or dividend payments, are
already factored into the ending-period value, this
term will not be needed for the computation. On a
test problem, if dividends or interest is shown
separately, simply add it to ending-period value.
The calculations are done below (dollar amounts
in thousands):
Period 1 (Dec 31, 2003, to Mar 31, 2004):
HPR = (($196.5 - $200)/$200) = (-3.5)/200 =
-1.75%.
Period 2 (Mar 31, 2004, to June 30, 2004):
HPR = (($200 - $196.5)/$196.5) = 3.5/196.5 =
+1.78%.
Period 3 (June 30, 2004, to July 30, 2004):
HPR = (($222 - $20) - $200)/$200) = 2/200 =
+1.00%.
Period 4 (July 30, 2004, to Sept 30, 2004):
HPR = ($243 - $222)/$222 = 21/222 = +9.46%.
Period 5 (Sept 30, 2004, to Dec 31, 2004):
HPR = (($250 - $2) - $243)/$243 = 5/243 =
+2.06%
Now we link the five periods together, by adding 1
to each HPR, multiplying all terms, and
subtracting 1 from the product, to find the
compounded time- weighted rate of return:
2004 return = ((1 + (-.0175))*(1 + 0.0178)*(1 +
0.01)*(1 + 0.0946)*(1 + 0.0206)) - 1 =
((0.9825)*(1.0178)*(1.01)*(1.0946)*(1.0206)) - 1
= (1.128288) - 1 = 0.128288, or 12.83%
(rounding to the nearest 1/100 of a percent).
Annualizing: Because our compounded
calculation was for one year, the annualized
figure is the same +12.83%. If the same portfolio
had a 2003 return of 20%, the two-year
compounded number would be ((1 + 0.20)*(1 +
0.1283)) - 1, or 35.40%. Annualize by adding 1,
and then taking to the 1/Y power, and then
subtracting 1: (1 + 0.3540)1/2 - 1 = 16.36%.
Note: The annualized number is the same as a
geometric average, a concept covered in the
statistics section.
Example: Money Weighted Returns
Calculating money-weighted returns will usually
require use of a financial calculator if there are
cash flows more than one period in the future.
Earlier we presented a case where a money-
weighted return for two periods was equal to the
IRR, where NPV = 0.
Answer:
For money-weighted returns covering a single
period, we know PV (inflows) - PV (outflows) = 0.
If we pay $100 for a stock today, and sell it in one
year later for $105, and collect a $2 dividend, we
have a money-weighted return or IRR = ($105)/(1
+ r) + ($2)/(1 + r) - $100 = $0. r = ($105 + $2)/
$100 - 1, or 7%.
Money-weighted return = time-weighted return for
a single period where the cash flow is received at
the end. If the period is any time frame other than
one year, take (1 + the result), raised to the
power 1/Y and subtract 1 to find the annualized
return.
DEals
PwC Deals Graduate Programme
T aportas la actitud y el talento
Cursars una preparacin inicial de 6 semanas
para preparar tu primera asignacin a un grupo
Te beneficiars de 800 horas de formacin en
tus primeros 3 aos de la mano de preparadores
del CFA pertenecientes al Instituto de Estudios
Burstiles y de los mejores profesionales de Deals
de PwC. Tendrs otros programas impartidos por
los formadores de referencia de la London School of
Economics and Political Science (LSC). Tendrs la
oportunidad de graduarte en el Master de Deals
de PwC y obtener tu certificacin CFA.
Trabajars en diferentes reas de Deals y te
involucrars en todo el ciclo de una transaccin en
un ambiente internacional.
En tu tercer ao, te especializars en el rea o
industria que mejor se adapte a ti y donde tengas
la oportunidad de desarrollar una carrera de
xito.
En tu cuarto ao y quinto ao podrs estar
involucrado en una asignacin internacional y
secodment en algn pas de la red.
Los profesionales de ms potencial con cinco
aos de experiencia en Deals sern reconocidos con
una formacin de MBA en una Escuela de Negocios
de referencia.
Certidicaicon de en 2 primris aos :en delas y el
CFA
Areade de deals:
1)M&A:orifinaicon y M&A
2)Strategy:conusltoria estratgica, due dilligince
coercial y operaicon,carve out,integracin post -deal
3)transactions services: valoraicon y analisi de
negocios, infraestrcutura y Project fianncie.
4)crisis: refinanciaicon y reestructuracin,
investigaicon de fraude y bancarrota,arbitraje
Para ser exeprto intenancionalen deals;
Aprendizaje prctico durante tus tres primeros aos que
combina training on the job con certificaciones profesionales.
Construir conocimiento trabajando en equipo, en un ambiente
de talento, escuchando y siendo odo. Ganar experiencia en
una industria especfica y rea de Deals.
Una red de colegas y contactos. Construir una red con
compaeros con los que trabajas, los clientes a los que
asesoras y las personas de influencia que conoces.
Construye una amplia experiencia en todo el ciclo de una
transaccin. S un consultor lder en nuestro negocio de
transacciones internacional.
A RR.HH
-Cmo es el plan de carrera para un recin graduado,
posibilidades de estancias en el extranjero,
- proyectos en comn con otras lneas de servicio de
la firma, etc.
-en la bolsa de la up salen algunas despcricionde
delpuesto que son capital de trbajo , seguimenet d
elineas de tnednica de industrias, deuda neta,calida
de ingresos
Gerente:
-peeguntas sobre mi y sobre tu futuro posible puesto
What's your name
Thank you very much for the interview and for
considering me in the selection process.
Mi nombre is italo caballeero arbulu estudio
eoncmia en la up me enccunetro en 9 ciclo y tengo
planeado culminar este ao. me gustan las
finanzas en especial las inversiones he relziado un
diplomado en la de analis de inversiones y
unsmeinario de politca de divnidnendos en la bolsa
de vlaores de lima, me gustas ver notaicas
eocnmis y de finanzas tcomplete el cruso de
bloomberg market concepst. Tambin me genera
curiosidad la infromatica he llevado ucrsos de
prgamicon en cibertec e infromatica para
ocnmicasta en la up. Asimismo he practica en una
consultaor de assocone spublico privadas en la
que yo junto a un eqeuip e proeycto multidisplianrio
comformado por eocnmistas admiasntradors y
abogaso, elabore modelso financirro tanto para la
valroizaod de los proyectos con le mtodo de flujo
de caja descontado y la evaluacion de
financiamientos de los proyectos para los fondos
de inersion. Adiconalmente elabroe reportes de
noticoas eoncmic y sectpriales
Y prestancion en espaol en ingles sobre los
proyectos de inverison apr apotenciales
inverisonistas y finalamente genera reuns para el
qeuipo de proeucytos con los ejefes de
proinverison
Planeo seguir en la rama deifnainzas ahora postulo
al rea de deals que es me intersa poruqe se ven
valorizaicones de mepresas es un arear que me
gustaria profunfizar y concer. Este ao tambin en
diciembre planeo postular al nivel 1 del cfa para
consolidar mas mi aprendizaje en fiannzas.
Y por ultimo me gustan mucho los deportes desde
pequeo practique futbol, basket, vley, por el
momento practico tenis de 2 a tres veces por
semna y soy voluntario en una ong llamada x-
runner que brinda serviciso saneamiento a familais
pobres en lima.
Banca de inversin Preguntas Entrevista
Ronda de persona
* Describir algunas de sus ventajas y desventajas?
Oportundiades de mejora: 3
1)Uno de mis retos es mejorar la disciplina de mis
salud fsica para ello hacer mas ejericio durante la
semana es asi que estoy llendo mas seguido al
gimnasio para mantenerme mas en forma y
sentrime mejor conmigo mismo.
2)Ademas de eso poner mas atencin en mis
horarios de comida y en las cossa que ingiero e
sun aspecto fiundmaental en el mi rendiemnto
acadamico y laboral, ne genral para todo el dia
3) otr aspecto es que anteriormente
inverta cuota importante de tiempo
en un solo curso complicado pero el
ao pasado se me dio la oportunidad
de llevar cursos pesados con otro
cruso mdeianamente fuertes y he
aprendido ser ms eficiente y a
organizar mejor mi tiempo,
estabelciendo horarios desde la hora
en que me leveantaba hasta que me
acostaba y es verdadermente
sorpredente todo el tiempo que se
puede aprovechar si estabelces una
buena rutina.
4)aveces suele ser un poco impaciente, quiero que
las cosas se den rpido o a mi ritmo, sin embargo
luego que he tenido disititnas experuincias de
voluntariado y de un intensivo trbajo en eqeuipo
he aprendido ponerme mejor en el lugar de las
personas, conocer sus inquietudes y sus
problemas
Fortalezas:
I)perseverancia : para mi estudiar eocnomia en la
up y relizar otras actividades extrcurrilaares tanto
deportivas en el caso de tenis o realizar
voluntariods en ongs ha sido un importnisimo
deasfioi en que el he pdoido descubrir que puedo
traspasr mis limites de tiempo o nergia y lograr
mantener un eqeuilibrio entre todas mis actividades
dairias
III) trabajr en eqeuipo :
Estoy convencido que equipo cmodmromado por 2
o mas personas peude lograr resultados
etraordinarios, lo he vivido cunado relice practicas
en la consultaro eramos un grupo comfrimado por
admisntradores, eocnomistas y abogados que
ofreciadn deiversas arsitads de los posiblems
problemas o solucines a conflictos que ocurran
en los proyectos.
IV)coimprometido
Creo que desde pequeo cuando estba en la
secudanrio me empee bastante en trzarme
algunos objetivos entre ellos ser tercio superuos
para estuida roenmia en la up y luego la up tb ha
adicionado en mi un extra importante de compriso,
dedicaicon y repsonsabilida hacia las cosas que
hago y como las hago que son los pasos
trascendentales para pbtenr un resultados ptimos.
Dibujar algo bonito que nos guste ver o hacer:
Un campo de tenis y yo con una raqueta jugando
dobles en una cancha de arcilla uqe quedan cerca
de mi casa y una pantalla viendo noticias
economicas y faincnieras nacional y del mundo.
El tenis implica mucha concentracin, persevancia
y fuerza mental para ganar a tus oponentes,
requiere de mucho entremaient y disicplina y
estartegia, asi como un poco de habilidad
deportiva. En el tenis se prioriza mucho la precisin
un movimiento mal hehco o una tecnia mal
empelada puede lelvar rpidamente a un error no
forzado o una bola en una psoicion desfavorable
que de te deja expuesto ante el rival. El jugar en
parejas en dobles reqeuire de habildiads
adiconales que en singles, se encsita mayor
corrodinaicon y comunaicon con tu compaero
conocerse perfectamente, saber como peinsa y
cuales son sus fortaleza y debildiades y como
podemos complementarnos
En una mepresa como el A la cual eta fromada
por un grupo de profesionales de gran nivel y
reputaicon en los servicios financieros y en la
amplia trayectoria y posicionamiento que ha tneido
el grupo como organizaicion tanto en el mecrado
nacional e internacional creo que precisa de varias
de estas habildiades. Y mas especifiacmente en las
reas que me gustaria dedesarrollar que son las
finanzas en espcial en als reas de inversiones y
CI&B creo que la cruva de aprednizaje es muy alta
y empinada lo cual indica que no solo se aprende
bastante sino tambin rpidamente. En estas reas
me gustara parender bastante sobre vlaoriziacon
de empresa, los procesos de compra y de venta de
empresas o acciones y manejod e potrtafolisod e
inversin, admeas otro aspecto es creo que puedo
crecer tanto en la empresa profesionalmente como
persona en cuanto mis habildiades y
conocmientos, con capcitaciones, ganar
experiencia en tranciones y ver los posible
s tendencioan fuutras de als industria y negociaos
y por ultimo una oportunidad de lnea de carrera
asumiendo mas responsabilidades
Ganas de aprender
Respeto con los dems jugadores
La habilidad de enfocarte cunado la rpesion es alta
Ocnstancia de nunca darte pro evencido
* Cul es tu mayor logro en la vida?
Un gran logro en en mi exepriencai priogesional
que fue mas bien compratidio con un eqeuipo
Trbajo multidispcilinario fue la obtencin dela
buena proc ed un proeycto comercia y
penitenciario.
Era un proeycto que se encargba de la
infraestrucutra epoenitneciaria, disei y
conctruccion de un nuevo penal para la ciduad de
lima a cambio de recibir el terrno del penal san
Jorge para que le consosrico tnega el derecho de
la cosntruccion e implementacin de un proecy
tocomercial compuesto pro galaerias, vivienda
estabelcimeinto comerciale, y tiendas
Tanto el costo de la conturcion del neuvo penal(54)
y el proecyo comecial(45) era de 100 MMde
doalres en un palzo de ejcucion de 3 aos., .
Los beneficios del estado eran obtener un nuevo
penal totalemnte eqeuipo y con mayor segurairad,
la renovaicon urbana en elc ecrdao delima, una
contribucin a la formalizaion del comrcio, y la
apmliaicond e vacante de reclusos
Deje mi enteorio trbajo porque sent que quera
trbajr en una mepresa una consultora mas grande
con mas proyectos, responsabilidades y
aspiraicones de lnea de carrera.
* Cul es la definicin de xito en sus trminos?
Hacerclo que mas tegusta y hacerlo lo mejor
posible
Preguntas tcnicas en una entrevista en banca
de inversin
Qu es un DCF? Explcame como haras
uno.
Cules son los diferente mtodos de
valoracin?
Cul es la diferencia entre un LIFO y un
FIFO?
Cundo emitiras deuda y cundo
acciones?
Qu es el EBIDTA?
Cmo vara el capital circulante si tus
proveedores te dan ms plazo para pagarles?
1532?
Cmo calculas el FCF?
Explcame lo que es la crisis en 5 minutos
y en ingls
Cmo calculas la depreciacin?
5 preguntas para ganarte al recruiter en una
entrevista de banca
1)pregutna la iuntimo de la entrevista, ks tienes
alguna pregunta?
Como se siente en banca d einveriso ne le
citibank?
1. Qu porcentaje del trabajo de un
analista/asociado (segn la posicin para la
que te ests entrevistando) es pitching y que
nivel de exposicin a la realizacin de modelos
puedo esperar?
2. Le hace poco acerca de una operacin que
desarrollo su grupo con la empresa X. Durante
esta operacin, quin facilito la financiacin
del deal y cun a menudo utiliza su grupo a
otros bancos como medio de financiacin?
4. Qu le influy a usted a la hora de decidir
desarrollar su vida profesional en este banco y
no en otro?
5. En este trabajo el horario puede ser muy
exigente y a veces puede ser difcil compaginar
vida personal y vida profesional Cmo lo hace
usted para compaginar la vida profesional y la
vida privada y familiar?
Bancos americanos: Goldman Sachs, JP Morgan,
Morgan Stanley, Merril Lynch, Citigroup
Resto de Bancos: UBS, Deutsche Bank, Barclays,
Nomura, Socit Gnrale, etc.
Boutiques de M&A: son asesores con un foco
local que no pueden prestar financiacin a sus
clientes. Suelen tener un tamao ms pequeo
y encargarse de operaciones a nivel nacional.
Se podra dividir en:
Internacionales: Rothschild, Lazard, Mediobanca,
etc.
Nacionales: Montalbn Atlas Capital, GBS
Finanzas, Arcano, AZ Capital, 360 Corporate, etc.
Big Four: las multinacionales denominadas Big
Four (PwC, Deloitte, E&Y y KPMG) tambin tienen
sus departamentos de M&A. Suelen tener
mandatos ms pequeos que, en ocasiones,
vienen derivados de un mandato de Due
Diligence Comercial o Financiero.

What stocks to invest
1. Health care: Envision Health
care (EVHC)
Recommended by: Michael Wiederhorn
from Oppenheimer (TipRanks gives him
a 5-star rating).
Stock price right now: $70 en diciembre
63 dolares
Wiederhorn says it will go to $87 a
share because the company is coming
off a merger with AmSurg in a very
strong position to be a dominant
player in hospital care, especially
services that don't require an overnight
stay.
2. Services: Delta Airlines (DAL)
Recommended by: Helane Becker from
Cowen & Co. (TripRanks gives her a 5-
star rating).
Stock price right now: $50
Becker says the stock will go to $58
because both leisure and business
travel continues to pick up, especially
as post-election optimism has soared.
RISING INTEREST RATES
Unlocking the vault for shareholders
Most banks profit margins should rise with
interest rates, but some stocks will get a
bigger jolt than others.
he companies with the most skin in the
game are banks, whose profit margins
generally improve as rates riseand whose
stocks have recently soared in anticipati
A NEW SPENDING BOOM
Exuberance again in the U.S.
These companies could benefit from confident
consumers and federal stimulus spending.
loser to home, a pickup in the U.S.
economy, combined with renewed calls for
greater infrastructure investment, bodes
well for companies like Pentair (PNR,
-0.74%), a w
We think theres going to be a long-term
supercycle of water investment that
supersedes any economic cycle, Ahlsten
says. That may not boost revenue next year
at Pentair, which focuses on filtering and
pumping water for residential and
industrial customers. But Ahlsten expects
Pentair to grow earnings 15% in 2017,
thanks to aggressive cost cutting

7. IBM (IBM)
By Benjamin Lau, CFA
Cloud, A.I. and mobility will drive Big
Blue back to glory in 2017.
IBM (IBM) is a turnaround story. Big
Blue is transforming its business to
meet the needs of the new era of
cloud, mobility, security, and artificial
intelligence. IBMs transformation had
begun to show some improvements in
2015. It gained momentum in 2016. I
think it will continue to bear fruit over
the next few years and lead to higher
revenues and profitability
The company has spent a tremendous
amount of money to invest in these areas
more than $5 billion in acquisitions in
2016, alone. These initiatives saw
accelerating growth of 16% in Q3 2016 and
now accounts for more than 40% of overall
firm revenues. One of IBMs most popular
products now is its artificial intelligence
platform, Watson, the same system that
beat two human contestants on Jeopardy!
4. Independence Realty Trust
(IRT)
By Brett Ewing
The run-up in interest rates has
caused a short-term rout across real
estate investment trusts, REITs.
Apartment REITs have been especially
hit. Most are more than 20% below
their 52-week highs.
The catalyst for Independence Realty
Trust (IRT) in 2017 lies in its necessity
for an equity raise. For years now, IRT
has been held down by the fact that it
pays fees to an external advisor
based on a number of assets under
management inside of the REIT.
Investors always rightly worry about
conflicts of interest with a REIT that is
externally managed and whose
incentives lie in buying as much as
possible, not making as much as
possible for shareholders.
This fact has made it a tougher sell to
many institutions. Thus it has
languished towards the very bottom
of the category regarding earnings
multiples. IRT raised the equity to buy
out the external manager and create
an internal team that is aligned with
shareholder interests.
Funds from operations, or FFO, is the
preferred earnings metric for REITs
instead of earnings per share (EPS),
which is used to evaluate non-real
estate stocks. Out of all the
companies in the apartment REIT
industry, there isn't a single one that
trades at less than a 15x price/FFO
ratio that is internally managed. The
average across the industry is 20x
price/FFO for 2016. Independence
trades for around 10x price/FFO.
IRT's dividend also sets itself apart
from the rest. At its current yield of
over 8%, it is more than double the
next closest internally managed
apartment REIT. Even if it dropped its
dividend down to a more respectable
payout ratio that was in-line with the
others in its space, it would still be
more than 25% higher than its closest
comps. Its ability to raise rents in the
Class B apartment space seems
positive for years to come because of
the solid employment environment
and rising income for middle-class
workers.
The biggest risks for IRT come from
interest rates rising and specifically
LIBOR (London Interbank Offered
Rate), which is directly tied to much of
IRT's debt. As it rises, the spread
between the net income the
properties produce and the debt
service required drops. This is typical
of most in the REIT space. But we
believe LIBOR will start to flatten out
toward the end of the first quarter of
2017 after inflationary outlooks
soften.
The internalization of IRT has created
a tradeable catalyst as the company
expands in the lucrative Class B
apartment space for years to come.
When the stigma of misalignment of
interests wears off, and investors
realize the discount valuations that
IRT offers in the growth phase of their
life cycle, the stock should perform
very favorably with a high margin of
safety.
Brett Ewing is the chief market
strategist at First Franklin Financial
Services with $110 million under
management in Tallahassee, Fla.
5. Forterra (FRTA)
By Eric Marshall
This recent IPO is a water
infrastructure products producer that
should see nice secular demand over
the next few years. Forterra (FRTA),
with roughly $1 billion in annual
revenues, has built a platform to add
additional infrastructure products.
Currently, there are few players
consolidating this industry. Forterra
could announce one or two accretive
acquisitions in the first half of 2017,
causing current street earnings
estimates to be revised up.
At Hodges Funds, we are especially
attracted to businesses that have high
barriers to entry. We
believe Forterra meets this criterion
due to the regional nature of shipping
large-diameter concrete pipe within a
100- to 150-mile radius from where it
is manufactured. As a result, Forterra
has limited competition within local
markets as well as rational pricing
power for its products.
Demand for water and drainage
products will be supported by the
replacement of aging public works
infrastructure across the entire
country. Management sees organic
demand growing at 6%-7% for
drainage in 2017, plus additional
growth from the Fast Act Money
requiring matching state funds of
$0.20 for each federal $1.00.
One negative is that Forterra has $1.1
billion of debt, which represents 4X its
enterprise value to EBITDA (earnings
before interest, taxes, depreciation
and amortization). We believe it will
reduce debt through cash flow over
the next couple of years, which should
support a higher P/E (price to
earnings) multiple for the stock.
Forterra trades at an attractive
valuation at just above 8X EV
(enterprise value)/EBITDA compared
to most cement and aggregate
players that are over 10X. Assuming
that Forterra is successful in
completing a couple of acquisitions in
the year ahead, the stock could trade
at $30 based on the valuations of
similar infrastructure stocks.
Eric Marshall is a portfolio manager at
Hodges Funds with $2.5 billion in
Dallas, Texas.
6. Dycom Industries (DY)
By Stephen DeNichilo, CFA
Dycom Industries (DY) is one of the
nations largest specialty contractors
whose business is driven by the
capital expenditure plans of the cable
and telecommunications industries. In
a market trading near all-time highs,
investors are best served by stocks
like Dycom that exhibit superior
organic growth attributes at
reasonable valuations with stock
prices below past peaks.
Dycom is the direct beneficiary of
what we see as a very long-term
trend. The U.S. is in the early innings
of a massive fiber-optic build-out in
response to ever-increasing demand
for lightning-fast internet speeds and
the exponential growth of data
consumption. Ask yourself a question:
Would you change internet providers
if a competitor offered consistently
faster service at a lower price?
Cable and telecom companies believe
the answer is yes and have
embarked on a veritable arms race of
fiber-optic deployments. For Dycom,
that has translated to a consistent
organic growth of approximately 25%
and a backlog of work that is up 30%
year-over-year. These dramatic fiber
expenditures have allowed Dycom to
achieve earnings per share growth
from $1.16/share in the fiscal year
2014 to near $5.00/share in 2016 a
trajectory we expect will continue.
Trading at less than 15x its fiscal year
2017 EPS, Dycom represents a rare
combination of growth and value in
this market.
Dycoms largest customer, AT&T(T),
illustrates the highly competitive
nature of the industry. Currently
serving under 3 million homes, AT&T
is committed to aggressively building
out its high-speed fiber network to
more than 12.5 million homes by
2019. Meanwhile, Comcast(CMCSA),
Charter, Verizon(VZ) and Altrice have
all publicly voiced a commitment to
faster speeds and increased
expenditures.

The stock has come under pressure

recently given worries that Google
(GOOGL), struggling to build its own
fiber network, will slow Dycoms
growth. At only 2% of revenues,
Google is merely a footnote. But the
Google noise may be creating an
attractive entry point into this multi-
year growth story.

Stephen DeNichilo, CFA, is portfolio

manager of Federated Investors,
Inc. with $364.3 billion under
management in New York City.

What not t buy

Acciones de america latina

Acciones de PEru

1- Depsitos a plazo

Es la alternativa ms familiar y conservadora para las

personas, se denomina as al dinero que es custodiado
por las entidades financieras por un plazo
mayor de treinta das, a cambio de una tasa de
inters (rentabilidad). Estos son ofrecidos por los
bancos, las cajas municipales, las cajas rurales y las
financieras. El monto mnimo para ahorrar es
desde S/.50.
Estas instituciones financieras estn reguladas y
supervisadas por la Superintendencia de Banca,
Seguros y AFP (SBS). Los depsitos estn protegidos
por el Fondo de Seguro de Depsitos hasta S/.97.644.
A continuacin, muestro las entidades con mayor tasa
de rendimiento efectivo anual para depsitos en soles
a la fecha, puede verse que destacan las cajas rurales y
municipales.
2- Fondos Mutuos
Un fondo mutuo es el patrimonio integrado por
aportes de personas naturales y jurdicas para
su inversin en valores de oferta pblica y
bienes que la ley permita, que administra una
entidad financiera por cuenta y riesgo de los
aportantes.
El buen devenir de las bolsas de valores de lima y de
las principales bolsas a nivel mundial durante el 2016
ha tenido un buen impacto en los rendimientos
de los fondos mutuos locales, sobre todo los de
renta variable (acciones). Aqu muestro los
fondos con mejores rendimientos durante el 201
e fondos mutuos en el mercado, desde los
conservadores hasta agresivos, lo ideal siempre es
invertir de acuerdo al perfil de riesgo del
inversionista.
3- Mercado de valores
La inversin en Bolsa de valores directamente
puede generar una mayor rentabilidad pero
tambin conlleva mayor riesgo, la compra
directa de acciones se realiza a travs de una sociedad
agente de bolsa.
La Bolsa de valores de Lima durante el 2016,
segn su ndice IGBVL rindi un 59%, siendo la
segunda bolsa de Amrica latina con mayor
rendimiento. Si nos ponemos un poco ms
internacionales, el ndice S&P500, el ndice
representativo de la bolsa americana ha
rendido 80% en los ltimos 5 aos.
Si invirtiera en Bolsa que acciones o en que
sectores debera fijarme para este 2017?
Esta es la pregunta del milln y requiere un anlisis
ms exhaustivo, por ello hoy mencionare solamente
un sector que veo que tiene un alto potencial de
crecimiento para los siguientes aos, el sector
de robtica y automatizacin.
Despus de la aparicin del Internet- hace poco
ms de 15 aos- los rpidos avances en
tecnologa, tales como la visin artificial,
sensores de movimiento y el reconocimiento de
imgenes y de voz, estn permitiendo a los
robots realizar trabajos cada vez ms
sofisticados y delicados en la industria. Esto ampla
su uso a una increble variedad de industrias y
aplicaciones, concretamente, en sectores
como la produccin, servicios y exploracin,
incluso en la industria automotriz donde est
creciendo mucho la participacin robtica.
Aqu muestro el grfico de un Fondo que invierte en
empresas del sector de robtica:
Fuente: www.morningstar.es
Este fondo llamado Robotics and Automation
ndex(solo tiene 3 aos desde su creacin), es
un ETF que cotiza en la Bolsa del Nasdaq y est
compuesto por empresas que fabrican fsicamente
robots y mquinas de automatizacin, hasta
compaas especializadas en los diferentes
tipos de software y tecnologa que permiten la
automatizacin
Qu es un ETF?
El ETF -Exchange Traded Fund por sus siglas en
ingls- o fondo negociable, es un producto financiero
que opera como un portafolio o fondo que cotiza
en una bolsa de valores y cuyo precio refleja
en todo momento el valor de los activos que
componen dicho fondo o portafolio de inversin. En
este sentido, un ETF puede estar formado por valores
de una regin, un pas, una industria o un
sector especfico.
Los ETFs han ganado mucha popularidad en los
ltimos aos, entre sus ventajas destacan 3
caractersticas:
1- Diversificacin.
Los ETFs permiten invertir en un fondo compuesto
por varios activos subyacentes, por ejemplo, el
ETF SPDR replica el comportamiento del
ndice accionario S&P500, o el ETF CRB que
est formado por materias primas y
commodities. Adems, existen fondos que agrupan
sectores industriales y que estn compuestos
exclusivamente por compaas del sector
petrolero, el de automviles o el sector tecnolgico,
por citar ejemplos.
2- Simplicidad.
Los ETFs cotizan en mercados centralizados,
conocidos como Bolsas de Valores, y su precio
flucta conforme a la variacin de los activos
subyacentes que componen el fondo cotizado. En
este sentido, comprar un ETF es tan sencillo
como comprar una simple accin, y el
inversionista puede realizar un seguimiento
diario de su fondo con suma facilidad, adems
de ello el ETF permite utilizar estrategias de
selling o venta corta, con lo cual incluso en
pocas de fuertes cadas en los mercados
puede generar rentabilidad.
3- Menores costos de transaccin.
Los ETFs son ms competitivos que un fondo mutuo
comn, dado que tienen menores costos de
transaccin al no tener cargos de
administracin ni condiciones especiales de
permanencia o costos por retiros anticipados
comunes en los fondos de inversin ordinarios.
ETF ROBO GLOBAL Robotics & Automation
Index
A medida que transcurren los aos el impacto en
nuestras vidas de la robtica y de la
automatizacin se hace cada vez ms evidente,
la robtica est dejando de ser un nicho de
mercado para ser una tecnologa fundamental
que se aplicar en todas las industrias y
mercados.

Hace poco el Director del Robotics Institute de

la Universidad de California, Henrick Christensen,
seal que el mercado de robtica podra crecer
hasta los US $1,2 billones para el 2025, desde
los $64 mil millones actuales, lo cual deja un
margen de crecimiento estratosfricamente grande,
y no es de extraar que se pueda dar este
crecimiento teniendo en cuenta todas las
reas donde la robtica tendr impacto, como
salud, hogares, entretenimiento, logstica,
automotriz, energa, aeronutica y hasta
telepresencia.

Qu factores estn influyendo en el crecimiento de

este sector?
Ante la fuerte proyeccin de crecimiento de este
sector usted puede invertir en empresas
Principalmente hay una convergencia entre la
particulares de este sector, pero si lo que
cada de precios de produccin y las mejoras
desea es realizar una inversin ms ponderada y
en el rendimiento de la robtica; la creciente
que requiera menos seguimiento puede
demanda de aplicaciones de alta complejidad; el
invertir a travs de un ETF, un ETF que
rpido aumento de la automatizacin a nivel
invierte en este sector es el ROBO GLOBAL,
global y una mayor necesidad de mejorar la
este ETF tiene poco ms de 3 aos desde su
productividad en las industrias.
creacin e invierte en cerca de 80 empresas de
este sector.
Segn el Robotics Institute de la Universidad de
California, el suministro anual de robots
A continuacin, muestro el comportamiento del ETF
industriales ha aumentado un 15% anual en
en el ltimo ao:
promedio entre 2009 y 2016, adems se
proyecta que siga creciendo a este ritmo hasta
el 2018, siendo Japn, China y Corea del sur,
los lderes en este creciente aumento de la
automatizacin.

Fuente: www.nasdaq.com
Para captar el valor econmico total de la industria
robtica y de la automatizacin, el ETF ROBO
GLOBAL ha identificado empresas a lo largo
de la cadena de valor de produccin. Esto
abarca, por ejemplo, desde las empresas que
fabrican fsicamente robots y mquinas de
automatizacin, hasta compaas
especializadas en software y tecnologas que
permiten la automatizacin.
Segn Boston Consulting Group, el rea de la
robtica que tiene mayor margen de
crecimiento para los siguientes aos es el de
los robots industriales, por ello si usted desea
realizar una inversin ms especializada
puede buscar empresas en ese nicho de mercado.
Recuerde que una inversin en este sector
debera tener un horizonte de tiempo mnimo
de 1 ao, incluso mientras el periodo de
maduracin sea mayor, mayor tambin sern
los retornos con el transcurrir del tiempo,
dado el alto potencial de crecimiento de este sector
a futuro.
En qu invertir
en el 2017?
Las polticas de Trump, el aumento de tasas de
referencia en EE.UU. y la desaceleracin china
sern algunos factores que marcarn la pauta en el
2017 y crearn oportunidades de inversin.
7 se perfila como un ao con bastantes
incertidumbres sobre los caminos que seguir la
economa, no solo en el mbito local sino tambin a
nivel internacional.
sidente de EE.UU., Donald Trump, tanto en
materia de regulacin bancaria y de boom de
infraestructura americana, marcarn la pauta de lo
que suceda en los mercados globales
na desea invertir, lo ms importante es
que tenga un portafolio diversificado,
recomienda Rebolledo.
Adems, debe considerar el horizonte
temporal que desea para su inversin y
el nivel de riesgo que est dispuesto a tener inversiones de tres a cinco
correr, aade. aos. As,a esas inversiones se les da
espacio para que generen
os inversionistas de largo plazo pueden incursionar
rentabilidades adecuadas, resalta.
en bienes inmuebles.
m aconseja invertir en acciones internacionales, Si por contrario, la persona solo cuenta
principalmente en la bolsa estadounidense. con un periodo corto para invertir,
bablemente las polticas gubernamentales de recomienda inclinarse por depsitos en
Donald Trump estn orientadas a tratar de mejorar cajas municipales, cuyas tasas estn
el sector de infraestructura, a tratar de desregular el
atractivas y seguirn probablemente
sector bancario y el sector famacutico
esa tendencia.
Bolsa local
La plaza limea seguira un comportamiento con
una mejora moderada
inculados a la demanda interna y al sector
construccin sern los motores que impulsen al
mercado accionario, sobre todo en el segundo
semestre del ao, precisa.
iere tener ms cautela en los sectores vinculados a
los metales preciosos, teniendo en cuenta el
aumento de tasas de referencia en EE.UU. y la
consecuente apreciacin del dlar frente a l Notticians de transasacciones

Renta Fija
ejecutivo recomienda ser cautos en las inversiones
Infraestructura lider el
en instrumentos de renta fija, principalmente por
los aumentos paulatinos que pueden haber en la mercado de fusiones el
tasas de referencia de la Fed.
ntara por recortar las duraciones de los portafolios 2016
de bonos y aprovechar de manera tctica, los bonos
vinculadas a riesgo crediticio que puedan ayudar a Operaciones en este sector
amortiguar el efecto de aumento en tasas de habran movido ms de US$800
referencia millones en el mercado de
Asimismo, el inversionista, de manera tctica,
fusiones y adquisiciones peruano.
podra optar por posicionarse en bonos de
pases emergentes cuyas polticas
monetarias puedan ser expansivas, por ejemplo, tenemos el caso del gigante brasileo
menciona. Odebrecht, que se vio obligado a vender casi el
60% de la operacin de la concesin vial Rutas de
Plazos Lima.
Rutas de Lima; Gaseoducto Sur Peruano, todava
azos dependen de la habilidad de
no pero se trata; Linea Amarilla, que se firm pero
tomar riesgo y de la liquidez de los todava no se cierra; H2Olmos.
inversionistas.
os montos de transaccin promedio de las
operaciones en este sector habran superado la
Si el inversionista tiene cifra de ms de US$800 millones. "Hay algunas de
flexibilidad, Rebolledo aconseja US$600, US$800, US$1.000",
Van a continuar algunas de estas transacciones
grandes de infraestructura que ya estamos
trabajando, pero creo que, adems, van a ver estas
nuevas (transacciones) que empiezan en retail,
energa, en minera, en agro
mrica Latina concentra el 2,3% de todas las
transacciones de fusiones y adquisiciones del
mundo, y en mensos de 3% en cuandto a vlaor de
de transascons.
Brasil lder en el mercado de fusiones y adquisiciones
durante el 2016. Durante el tercer trimestre este
pas concentr el 43% del total de los acuerdos
generados de fusiones y adquisiciones en Latinoamrica.
103 operaciones,inversin significan ms de
US$14.000 millones. Mientras que peru en el trcecr
trmete 18 operaciones en temrinos de inverison 65 MM
doalres
Las operaciones en Per aumentaron 20% este
ao hasta 131 operaciones. El Per descendi
al ltimo lugar de las fusiones y
adquisiciones (M&A, en ingls), debido a
menores valoraciones y pese al incremento
de estas operaciones el 2016. Se estn
ahciendo mas trnasacicone de empresa
mediana pero de menro vlaor
En el caso de la salud, los proyectos
gubernamentales de inversiones en
Asociaciones Pblico Privadas generan un
ambiente favorable de percepcin en los
inversionistas, y adems sera un factor dinmico
en el mercado transaccional para el prximo ao,
concluy.
Del 2015:
La millonaria adquisicin de Corporacin
Lindley, comercializador de Inca Kola, por
parte de Arca Continental, se sell mediante un
acuerdo, el 10 de septiembre. La fusin y
adquisicin estuvo valuada en US$760
millones.
La firma brasilea, Votorantim, elev su
participacin en la minera peruana, Milpo,
para lo cual compr acciones por un valor
de US$118,35 millones. Como agente de ventas
participaron Sociedad Agente de Bolsa, Grupo Coril
Sociedad Agente de Bolsa, entre otros.
de Gas del Per en una fusin y adquisicin de
cerca de Enagas ingres al accionariado de
Transportadora de Gas del Per en una fusin y
adquisicin de cerca de US$97 millones. Uno de
los agentes de venta fue la Corporacion Financiera de
Inversiones. (F
El Rancho lleg un acuerdo con la empresa
constructora Viva GyM, por US$49,8 millonesoto:
Andina)
La firma experta en soluciones para el mercado de
valores, Cavali S.A, se fusion con la Bolsa de
Valores de Lima (BVL) por US$38,07 millones
Aumentan las operaciones de M&A en el
pas por la mayor participacin de
extranjeros y de sectores
vinculados a la demanda interna
Las transacciones de extranjeros vienen
sosteniendo el crecimiento del mercado de
M&A peruano. A mayo se registran 58
operaciones, por US$1,595 millones, y los
extranjeros participaron en 35 de ellas (ver
grfico). El Per sigue siendo un receptor de
inversionistas, dice Daniel Hernndez,
analista de la consultora espaola TTR. Los
inversionistas de Chile, Estados Unidos y
Mxico sumaron nueve transacciones, agrega
Scotiabank anunci el cierre de la operacin de
compra de los negocios de banca personal y
comercial de Citibank en el Per, tras haber obtenido
el permiso de la Superintendencia de Banca, Seguros
y AFP (SBS) para la operacin, valorizada en US$295
millones
Creemos que esta transaccin es la mejor opcin
para nuestros clientes de banca de personal y
comercial, accionistas y empleados, y nos
posiciona para enfocarnos en nuestros clientes
corporativos e institucionales, ofreciendo mejores
servicios a travs de nuestra presencia global
The International Financial Reporting
Standards (IFRS) - the accounting standard used
in more than 110 countries - has some key
differences from the U.S. Generally Accepted
Accounting Principles (GAAP). At the
conceptually level, IFRS is considered more of a
"principles based" accounting standard in
contrast to U.S. GAAP which is considered
more "rules based." By being more
"principles based", IFRS, arguably, represents
and captures the economics of a transaction
better than U.S. GAAP. Some of differences
between the two accounting frameworks are
highlighted below:
Intangibles
The treatment of acquired intangible assets helps
illustrate why IFRS is considered more "principles
based." Acquired intangible assets under U.S.
GAAP are recognized at fair value, while under
IFRS, it is only recognized if the asset will have a
future economic benefit and has measured
reliability. Intangible assets are things like R&D
and advertising costs.
Inventory Costs
Under IFRS, the last-in, first-out (LIFO) method
for accounting for inventory costs is not allowed.
Under U.S. GAAP, either LIFO or first-in, first-
out (FIFO) inventory estimates can be used. The
move to a single method of inventory costing
could lead to enhanced comparability between
countries, and remove the need for analysts to
adjust LIFO inventories in their comparison
analysis.
Write Downs
Under IFRS, if inventory is written down, the write
down can be reversed in future periods if specific
criteria are met. Under U.S. GAAP, once
inventory has been written down, any reversal is
prohibited. (To learn more, check
out International Reporting Standards Gain
Global Recognition)