Finance Grid is proud to be the first financial training company which offers the full time CFA Level 1 training course in the Milton Keynes area. Finance Grid’s CFA Training Courses will beginning on March 6th 2012. You have the option of an early start date on March 6th or you can start a week later on the March 13th 2012. The Late Start Option commences on March 20th 2012 and even with the late start option, the 10 week course will complete in time for you to sit the exam on 2nd June 2012.

Finance Grid Ltd. is a London based financial training company which has brough to market the most innovative learning materials for the CFA Level 1 training program. In addition to self study courses, Finance Grid also offers classroom training programs in Croxley, Hertfordshire. Finance Grid is proud to be the first to bring its CFA full time classroom training course to Milton Keynes.

State of the art teaching facilities at the Milton Keynes Conference Center will ensure a productive 10 week training and our courses are authenticated as being conducted only by qualified and experienced CFA tutors who have themselves achieved the prestigious CFA qualification as well as have had the experience of teaching for the CFA training program in prestigious London universities and training organisations. Sabdezar Ilahi of LUMS, (CFA, MBA, BBA), will be conducting the CFA training classes in Milton Keynes, alongwith Moeen Khawaja of Leicester University (MBA, MSc, BEng) as the senior learning counsellor for the course. Sabdezar received her CFA charter in 2007 and has taught CFA training courses at London School of Business and Finance as well as Quartic Training London. Sabdezar’s experience as a City Financial Trainer now comes to Milton Keynes where you now have the opportunity to achieve success in the CFA exam, closer to home.

Finance Grid’s CFA course prices are extremely competitively priced and we promise to price match any other CFA prep provider for the CFA Level 1 full training course in Hertfordshire, Milton Keynes and Luton. In addition to our price guarantee, we also offer a success guarantee to our candidates for first attempt success in the CFA Level 1 exam or free resit of our training course at no further expense. This is how confident we are that you will pass the exam.

The Milton Keynes courses carry a complementary offer this term only, of access to all of Finance Grid’s learning resources, free of charge and students will be able to use these learning tools on their Iphone, Android phones, tablets, IPad, Kindle etc.

Study Program: Download the CFA classes Timetable and Application Form for the CFA Level 1 training course in Milton Keynes now. We offer small class sizes for maximum tutor contact, so places are limited. You are advised to act early to book your place for the Spring term 2012.

Course Requirements and Prerequisites: Minimum Bachelors degree in any discipline OR 4 years of professional work experience in Investment Management and Finance. Students who have completed the first year of their Bachelors programm can also sit for the CFA Level 1 Exam.

Course Timings: Finance Grid’s courses in Milton Keynes span over a 10 week period, and there are 2 classes each week (during week days). For each class, students will have 4 hour contact with the tutor. Your study materials for the Finance Grid CFA Level 1 training program are included in the price of the course, so you wont have to buy any further study notes for your preparation. A minimum of 3 (although we try to get 4 tests in) progress tests will ensure that you keep on track. You will be required to put in atleast 100 hours of preparation as well as attend the classes in order to succeed in the exam.

Download the Timetables for CFA Level 1 Course in Milton Keynes:  CFA Level 1 Timetable – March to June 2012 – June 2012 Exam

Download the Application Form to Enroll for this Course: CFA Level 1 Application – March to June 2012 – June 2012 Exam

CFA® Level 1 – Corporate Finance Topic: Dividends:

Dividends are a mechanism for corporations to distribute cash to their shareholders. The company’s board of directors, approves the dividend, an in most jurisdictions, especially in Europe, this requires the approval of the shareholders. In the case of common stock holders, the payment of dividends is a discretionary matter (Dividends on
Preferred Shares may be obligatory).

Tax Treatment of Dividends (CFA Level 1):

At the level of the company which declares the dividend, these payments are not deductible for tax purposes. This is in contrast to interest payments made to providers of debt capital, which are tax-deductible for the company. From the perspective of the shareholders receiving the dividend, these payments may be taxable, but are accorded a
different treatment from capital gains, in most cases.

Dividends as a Signal (CFA Level 1):

Companies strive to maintain a constant or steadily growing level of dividends, since dividends are viewed in the markets as a signal of sustained profitability. Dividends may be paid as regular or irregular cash payments, or in the form of additional shares of the company.

Regular Cash Dividends(CFA Level 1):

The most prevalent form of distributing dividends is in the form of regular, cash dividends. Regular Dividends may be paid according to a fixed schedule of payments, which may be; Quarterly (U.S.and Canada), Semi-annually (Europe and Japan), or Annually (China). A steady or increasing level of regular cash dividends has the impact of increasing the price of the company’s shares in the market. An unexpected increase in dividends is a positive signal for share prices.

Dividend Re-investment Plans ‘DRIPs’:(CFA Level 1)

A dividend reinvestment plan allows the company’s shareholders to re-invest the dividend proceeds automatically, into new shares of the company. The company fulfils this
reinvestment through the following mechanisms;

•The company issues new shares to the shareholder as a ‘Scrip Dividend Scheme’,

•The company may have permission to use either of the above approaches.

Advantages and Disadvantages of DRIPs: (CFA Level 1)

Extra or Irregular Dividends:

Companies with cyclical earnings patterns are unable to issue regular dividends, and may use irregular dividend distributions during times of higher earnings. Some companies may use smaller, regular dividend payments according to a set dividend payout policy, but supplement these through additional, extra dividends during high earning periods.

Example: A company has had a policy of a 20% regular dividend payout ratio (cash dividend per share, divided by earnings per share ‘EPS’) for the last five years. During 2011, the company has 1million shares outstanding. Its EPS in 2011 is $6 and it makes a cash dividend distribution of $1.50 per share in 2011. 1) Calculate the amount of extra (irregular) dividends per share, distributed by the company? 2) Also calculate the dividend payout ratio for the company’s shares in 2011.

Answer:

1) According to the policy dividend payout ratio, the company’s regular cash dividends per share should have been $1.2 (0.2 x $6). Hence the company issued an extra cash
dividend of $0.3 per share in 2011 ($1.50 – $ 1.20)

2) In 2011, the payout ratio = $1.50/$6 = 25%

Liquidating Dividends: (CFA Level 1)

Liquidating Dividends are distributed by a company under the following circumstances;

1.The company is ceasing operations. In this case, the company’s debtors are first paid off. The remaining Net Assets are liquidated to make a payment to the shareholders.

2.The company is selling a division or a portion of itself. In this case, the company does not cease to exist, rather it may be divesting from a particular business segment, or a regional investment.

3.In the third case, the company pays out a dividend which exceeds its level of retained earnings (accumulated through the income earned over the years), This third type of liquidating dividend impairs the capital of the company, and reduces the equity providers’ share of ownership relative to debt providers share, in the capital contributions.

Please review the latest curriculum for the next exam by browing through our products page.

CFA Level 1 – Study Session 4 – CFA Level 1 Microeconomic Analysis – Finance Grid – DOWNLOAD PDF BELOW!!!

http://www.finance-grid.com/wp-content/uploads/CFA-Level-1-Study-Session-4-CFA-Level-1-Microeconomic-Analysis-Finance-Grid.pdf

CFA® Level I Program: 100 Hour Revision Guide. Available only through Finance Grid. See sample question bank for CFA Level 1 Study Session 4 below:

Finance Grid – CFA Level 1
SS 4 Question Database: CIRCLE THE CORRECT RESPONSE: (Please note, in the responses below, 1,2,3 correspond to A, B, C respectively. So if correct answer is indicated as B, then the correct answer you will take should be the one numbered 2.)

1. ‘Command Systems’ represent a method of organising production of goods and services,
   through a formalised hierarchy, in which;
   1. Commands flow downwards in a
      hierarchy and information flows laterally through the organisation, in order to
      carry out the demands.
   2. Commands flow downwards whereas
      information flows upwards, downwards, and laterally, in an organised teamwork
      structure to achieve maximum efficiency.
   3. Commands flow downwards whereas
      information flows upwards, as in the case of a military hierarchy.

 (CFA Level 1 – Correct Answer is C.)

1. A ‘Subsidy’on agricultural output will have the following effects;
   1. The subsidy functions like a negative
      tax on suppliers, hence the supply curve will shift downwards and to the right,
      just as if the costs to the suppliers had been reduced. The price paid by
      consumers will reduce by an amount equal to the subsidy.
   2. The subsidy functions like a negative tax on suppliers, hence the supply curve will shift downwards and to the right, just as if the costs to the suppliers had been reduced. The price paid by consumers will reduce by an amount less than the subsidy.
   3. The subsidy functions like a negative
      tax on consumers, hence the demand curve will shift towards the right, and the
      price paid by consumers will be lowered by the amount of the subsidy.

 (CFA Level 1 – Correct Answer is B.)

1. ‘Price Elasticity of Demand’ can be used to measure the demand response of consumers to
   price changes across various products because;
   1. Elasticity consistently measures the
      slope of the various demand curves of different products, thus allowing for a
      direct comparability.
   2. Products have similar price
      elasticity of demand when they are ‘complementary products’, such as milk and
      tea.
   3. Elasticity is a ‘unit-free’ measure.

 (CFA Level 1 – Correct Answer is C.)

1. ‘Allocative Efficiency’ is calibrated by evaluating marginal cost and marginal
   benefit.
   1. If MC < MB, the output level is
      less than the optimal quantity and output should be increased, since production
      cost is lower than the value to customer.
   2. If MB = MC, Allocative efficiency
      cannot be achieved, since no calibration is possible at the point where MB and
      MC are equal.
   3. If MC > MB, the output level
      exceeds the optimal quantity and output should be decreased, since value to
      consumer exceeds production costs.

 (CFA Level 1 – Correct Answer is A.)

1. MSB is the aggregate of the MB curves
   of all consumers and the MSC is the aggregate of the MC curve of all producers.
   In determining the optimal level of output through ‘Allocative Efficiency’;
   1. Output and price level will be
      located to the left of the intersection of MSB and MSC, since operating towards
      the right side of this intersection will deliver dead-weight losses to society.
   2. Output and price level will be
      located at the intersection of MSB and MSC, since there are dead-weight losses
      to society at this point.
   3. Output and price level will be
      located towards the right of the intersection of MSB and MSC, since operating
      exactly at the intersection or towards the left side of this intersection, will
      result in under-production relative to capacity.

 (CFA Level 1 – Correct Answer is B)

1. In the case of agricultural
   production, a bumper crop means that the vertical ‘Momentary Supply Curve’will be to the right of its normal location. A poor harvest on the other hand will shift the momentary supply curve to the left of its normal location. What is the effect on prices of agricultural products and total revenue to the farmer community?
   1. A bumper crop will lower the price
      paid by consumers and the total revenue to the farmer community will be lower
      since the demand curve is inelastic.
   2. A bumper crop will lower the price
      paid by consumers and the total revenue to the farmer community will be higher
      because of the bumper crop.
   3. A poor harvest will increase the
      price paid by consumers and reduce the total revenue to the farmer community
      due to the poor harvest.

 (CFA Level 1 – Correct Answer is A)

1. Three candidates studying for their
   economics exam are discussing the concept of ‘Price Elasticity of Demand’ and expressing their casual
   observations. Which student has the best understanding of the concept?
   1. George: “A larger number of close
      substitutes will mean that consumers will be fussy about price changes and quickly
      switch to the substitute product if prices are raised even slightly – That is
      if the products really are close substitutes”.
   2. Jonathan: “I feel that it is the
      quality of the product and not the number of close substitutes available in the
      market, which determines the sensitivity of consumers to price changes”.
   3. Samantha: “Fewer number of substitute
      products available in the market, make the consumers more sensitive to price
      changes – You see there is not much they can choose from”.

 (CFA Level 1 – Correct Answer is A)

1. The concept of a ‘Rent Ceiling’ can be most accurately described by which of the
   following statements?
   1. Rent ceilings lower the price, create
      a shortage, and may result in illegal price hikes due to consumers wishing to
      bypass the shortage.
   2. Rent ceilings raise the ceiling
      price, create a shortage, and may result in illegal price hikes due to
      consumers wishing to bypass the shortage.
   3. Rent ceilings lower the ceiling price,
      create a surplus supply, and do not result in illegal price hikes.

 (CFA Level 1 – Correct Answer is A)

1.  Implementing a ‘Production Quota’as an intervention in farm markets;
   1. Overall output is decreased and
      consumers pay a lower price. Dead-weight losses are eliminated.
   2. The overall output is unaffected,
      consumers pay a lower price and suppliers incur a lower cost. Dead-weight
      losses are eliminated.
   3. The overall output is decreased and
      consumers pay a higher price. Dead-weight losses are created.

 (CFA Level 1 – Correct Answer is C)

1. Identify the most accurate statement
   below, relating to the ‘Principal-Agent’
   problem;
   1. The shareholders are the principals,
      whereas the firm and its managers are the agents.
   2. The firm and its senior management
      are the principals, and all other staff members are the agents.
   3. The firm is the principal, whereas
      the managers and other staff members are the agents.

 (CFA Level 1 – Correct Answer is C)

1. Equilibrium in the ‘Labour Markets’ is determined at the
   intersection of;
   1. The long run labour supply curve and
      the demand curve for labour
   2. The short run labour supply curve and
      the demand curve for labour
   3. The medium term labour supply curve
      and the demand curve for labour

 (CFA Level 1 – Correct Answer is B)

1. The various outcomes of intervention
   in markets for ‘Illegal Goods’,
   through fines on sellers, fines or buyers, or both, can be most accurately
   described as follows;
   1. A fine on sellers will lower output
      and lower prices
   2. A fine on buyers will lower output
      and lower prices
   3. A fine on both buyers and sellers, of
      an equal amount, will lower output drastically as well as increase prices.

(CFA Level 1 – Correct Answer is B)

1. A ‘Rent-Ceiling’will be determined at;
   1. A price exactly equal to the
      prevailing equilibrium price level, so that equilibrium price level is not
      disturbed.
   2. A price above the equilibrium price
      level, so that producers can charge a price higher than equilibrium prices for
      efficient allocation of scarce resources.
   3. A price below the equilibrium price
      level, so that consumers are charged a price lower than the equilibrium prices.

(CFA Level 1 – Correct Answer is C)

1. For a straight line, downward sloping
   demand curve of a particular product, the ‘Price
   Elasticity of Demand’will be;
   1. Elastic where the demand curve
      touches the x-axis and the y-axis, but inelastic over the remaining portion of
      the demand curve.
   2. Elastic above the mid-point,
      unit-elastic at the mid-point, and inelastic below the mid-point.
   3. Constant at all points since the
      demand curve is a straight line and has a constant slope.

(CFA Level 1 – Correct Answer is B)

1. ‘Normal Profit’
   is the profit that an entrepreneur can earn through an alternative, best case
   opportunity. Indicate the proper classification of normal profit, among the
   statements below;
   1. Normal Profit is an ‘Implicit
      Opportunity Cost’ and is subtracted from total revenue, along with other
      opportunity costs, to arrive at ‘Economic Profit’.
   2. Normal Profit is part of ‘Economic
      Profit’ and should not be classified as an opportunity cost, since it is a
      profit rather than a cost.
   3. Normal Profit is an ‘Explicit
      Opportunity Cost’ and is subtracted from total revenue in order to arrive at
      ‘Economic Profit’.

(Correct Answer is A)

1. Which of the following statements
   about the ‘Measures of Market
   Concentration’is most accurate?
   1. The ‘Herfindahl-Hirschman’ Index is
      the ratio of; the ‘sum of the squares’ of the % market shares of all firms
      operating in the market to the total size of the market in terms of ‘money
      value of sales’.
   2. The ‘N-Firm Concentration Ratio’ is
      ratio of; the ‘money value of sales’ of the ‘N’ largest firms operating in the
      market to the ‘money value of sales’ of all firms operating in the market.
   3. The ‘N-Firm Concentration Ratio’ is
      ‘sum of the squares’ of the % market shares of the ‘N’ largest firms operating
      in the market.

 (CFA Level 1 – Correct Answer is B)

1. The effects of a ‘Minimum Wage’ can be best described by which of the following
   statement.
   1. Implementing a minimum wage creates
      economic inefficiency, creating dead-weight losses, reducing the surplus to
      both labour as well as hiring firms. The firms cannot accommodate all the
      workers willing to work at the minimum wage.
   2. Implementing a minimum wage creates
      economic inefficiency, but improves social efficiency and boosts the morale of
      the workers. ‘Dead-weight’ losses and ‘Search’ costs are thus negligible in the
      context of benefit to society.
   3. Implementing a minimum wage reduces
      the hiring firms’ surplus but increases the surplus to the labour because of a
      higher minimum wage compared to the equilibrium wage level. The total surplus
      lost and surplus gained means that total economic efficiency does not change.

 (CFA Level 1 – Correct Answer is A)

1.  Three analysts are discussing the ‘Constraints faced by a Firm’. Identify
   the analyst making the most correct statement;
   1. Sarosh: In today’s day and age, at
      least there are no constraints in accessing and analysing information in order
      to enhance profitability. Market constraints such as prices, labour access and
      raw material access are the real constraints.
   2. Andreas: Access to information and
      access to technology create profit enhancing opportunities and there are
      virtually no limits to these since information is easily accessible and
      technology keeps ahead of the commercial requirements of businesses. Market
      constraints are irrelevant if the best information and most updated
      technologies are used.
   3. Zain: Market constraints such as
      price levels, labour access and access to other resources, can place constraints
      on a firm’s ability to enhance profits. Also resources that can be spent on
      information access are limited and stage of technology can itself place a
      constraint on profit enhancement.

 (CFA Level 1 – Correct Answer is C)

1. In considering the perspective of an
   individual consumer, which statement best explains the price paid and the ‘Consumer Surplus’achieved?
   1. The consumer will pay a price at the
      intersection of his or her own MB and the MC curve of the individual producer
      whose product is being purchased. Both individuals struggle to achieve the
      surplus for themselves.
   2. Each individual consumer will always
      pay the prevailing market price for any quantity that the individual wishes to
      consumer. For this reason, there is no consumer’s surplus for the individual.
   3. It is possible that the value derived
      by an individual consumer, exceeds the price paid by the consumer, thus
      generating a consumer’s surplus for the individual.

 (CFA Level 1 – Correct Answer is C)

1. Which statement below, best describes
   how ‘Market Price is determined’ for
   any product or service?
   1. Market price is determined at the
      intersection of the aggregate MC curve of all producers of the product and the aggregate
      MB curve of all consumers of the product.
   2. Market price is determined at the
      intersection of the MB curve of an individual consumer and the aggregate MC
      curve of all producers, since the individual has unlimited choice.
   3. Market price is determined at the
      intersection of MB curve of the individual consumer and the MC curve of the
      individual producer whose product is being purchased.

 (CFA Level 1 – Correct Answer is A)

1. Which statement best describes how ‘Quantity produced by an Individual
   Producer’is determined?
   1. The intersection of the individual
      producer’s MC curve and the aggregate MB curve of his loyal customer base will
      determine the level of output produced by an individual producer.
   2. The individual producer will receive
      the prevailing market price will increase output levels up to the point that
      his own MC becomes equal to the market price. That output level will be the
      quantity produced by an individual producer.
   3. The individual producer will receive
      the prevailing market price and will attempt to maximize his market share,
      producing output equal to the maximum production capacity he possesses.

 (Correct Answer is B)

1.   Three
   analysts are discussing ‘Agricultural
   Products’, which statement is most accurate?
   1. Robert: The demand for agricultural
      products is downward sloping but inelastic, whereas the momentary supply curve
      for agricultural products, immediately after a harvest is perfectly inelastic.
   2. James: The demand for agricultural
      products is inelastic immediately after a harvest. The momentary supply curve
      for agricultural products is upward sloping and inelastic as well. This is why
      the government must intervene through subsidies.
   3. Joshua: The demand for agricultural
      products is perfectly elastic. The momentary supply curve is vertical
      immediately after a harvest, but afterwards it may be upward sloping.

 (Correct answer is A)

1. Complete the sentence through the
   most accurate statement below; “Opportunity
   costs comprise of…”
   1. Explicit costs as well as implicit
      costs, and economic profit is total revenue minus opportunity costs.
   2. Implicit costs such as foregone
      interest and loss due to economic depreciation, however opportunity costs are
      not relevant in the calculation of economic profit. Explicit costs are excluded
      from opportunity costs and are used in the calculation of accounting profit.
   3. Explicit costs and implicit costs
      which have been diverted from other projects, and accounting profit is total
      revenue minus all opportunity costs.

 (Correct Answer is A)

1. Unlimited liability will be faced by
   owners in the case of which ‘Company
   Incorporation’status?
   1. In a Corporation and Partnership
      only, in their collective or joint capacities.
   2. In a Sole Proprietorship in
      individual capacity, jointly in the case of a Partnership, and collectively in
      the case of a Corporation.
   3. In a Sole Proprietorship in
      individual capacity and jointly in the case of a Partnership.

 (Correct Answer is C)

1. ‘Income Elasticity of Demand’is defined as;
   1. The % change in price elasticity of
      quantity demanded, divided by the % change in income levels.
   2. The % change in quantity demanded,
      divided by the % change in income of the consumers.
   3.  The % change in supply elasticity of quantity
      demanded, divided by the % change in income levels of producers.

 (Correct Answer is B)

1. According to the ‘Fairness Principle in Utilitarianism’….. ;
   1. Progressive taxes are an efficient
      mechanism for taxing the rich to pay for services to the poor, such that
      equality is achieved between them.
   2. Progressive taxes benefit the poor,
      however there is no overall benefit to society since the advantage extended to
      the poor is offset by the taxation disadvantage to the rich.
   3. Progressive taxation is an
      inefficient mechanism and everyone should be taxed at the same rate, in order
      to achieve fairness and maximum utility to society.

 (Correct Answer is A)

1. The effects of a ‘Rent Ceiling’include;
   1. Economic inefficiency and dead-weight
      losses, improved social efficiency due to lower prices and improvement in at
      least the consumer’s surplus as ‘Search Activity’ decreases.
   2. Economic inefficiency and dead-weight
      losses, shrinkage of the consumer surplus as well as producer surplus, lower
      prices, and potential loss due to increased ‘Search Activity’.
   3. Economic inefficiency and dead-weight
      losses, shrinkage of the consumer surplus as well as producer surplus,
      potential loss due to increased ‘Search Activity’ as a result of higher prices.

 (Correct Answer is B)

1. ‘Opportunity Costs’represent;
   1. The cost of the foregone alternative,
      which has the lowest value among the alternatives that have been foregone.
   2. The cost of the foregone alternative,
      which has the highest value among the alternatives that have been foregone.
   3. The cost of the foregone alternative,
      which has a value closest to the option that is actually undertaken.

 (Correct Answer is B)

1.  According to the ‘Fairness Principle of Symmetry’;
   1. The distribution of wealth should be
      equal.
   2. All resources should be under private
      ownership and the distribution of wealth should be fair rather that equal.
   3. All resources should be symmetrically
      distributed; 50% in private ownership and 50% in public ownership.

(Correct answer is B)

1. Complete the statement in quotes
   using the best statement from the choices provided. “The coordination of economic activities such as hiring and organising
   factors of production, determining output levels to match demand, and the
   distribution and selling of output ….”;
   1. Is best carried out through the
      combined actions of firms as well as the market mechanism, and this ensures the
      viability of the economic system as a whole.
   2. Is best carried out through the
      market mechanism, since the market mechanism ensures the lowest possible cost
      for such coordination.
   3. Is best carried out through the firms
      since the firms can carry out such activities at the lowest possible cost,
      since this ensures the economic viability of the firms themselves.

 (Correct Answer is C)

1. Regarding ‘Variable and Fixed Resource Inputs’, it can be said most accurately
   that;
   1. In the short run only variable inputs
      can be changed, whereas in the long run all resource inputs can be changed.
   2. In the short run only variable inputs
      can be changed constantly, whereas fixed resource inputs can be changed only at
      fixed intervals.
   3. In the short run none of the resource
      inputs can be changed, whereas variable inputs are changeable in the long run.

 (Correct Answer is A)

1. The definition of ‘Cross Elasticity of Demand’ is closest
   to which of the following statements?
   1. The % change in quantity demanded of
      product ‘A’ divided by the % change in price of product ‘B’, which may be a
      substitute or complement of product ‘A’.
   2. The product of the % change in
      quantity demanded of product ‘A’ and the % change in quantity demanded of
      product ‘B’, which may be a substitute or complement of product ‘A’.
   3. The ratio of the % change in quantity
      demanded of product ‘A’ and the % change in price of product ‘A’.

 (Correct Answer is A)

1.  Consider the ‘Distinguishing Features of the Various Market Structures’: A large
   number of firms, differentiated products and a fairly high level of
   competition, is a distinguishing feature of;
   1. ‘Monopolistic Competition’ only.
   2. Both ‘Perfect Competition’ and
      ‘Monopolistic Competition’
   3. Both ‘Monopolistic Competition’ and
      ‘Oligopoly’.

 (Correct Answer is A)

1. ‘Production
   Efficiency’ can be viewed along which of the following dimensions;
   1. ‘Technological Efficiency’ and
      ‘Market Efficiency’; which entails the use of least amount of input resources
      and least amount of marketing resources to get optimal results.
   2. ‘Economic Efficiency’ and
      ‘Technological Efficiency’; which entails the lowest cost of production and use
      of the least amount of input resources.
   3. ‘Technological Efficiency’ and
      ‘Operational Efficiency’; which entails the use of least amount of input
      resources due to technological efficiency.

 (Correct Answer is B)

1. An economist has calculated the ‘Income Elasticity of Demand’ for three
   products; ‘A’ = 1.3, ‘B’ = 0.5, ‘C’ = – 0.3. Which of the statements below,
   about the economic categorisation of the three products is most accurate?
   1. ‘A’ is a ‘Luxury, Normal Good’, ‘B is
      a ‘Necessity, Normal Good’ and ‘C is an ‘Inferior Good’.
   2. ‘A’ is a ‘Necessity, Normal Good’, ‘B
      is a ‘Luxury, Normal Good’ and ‘C is an ‘Inferior Good’.
   3. ‘C’ is an ‘Inferior Good’ since its
      quantity demanded decreases when income increases, hence the negative sign. ‘A’
      and ‘B’ are both ‘Normal Goods’.

 (Correct Answer is A)

1. Which of the following statements
   best describes the nature of ‘Demand and
   Supply Curves’, over different time frames?
   1. The short run supply curve is
      horizontal, the long run supply curve is vertical (perfectly inelastic), and
      the demand curve is downward sloping from left to right.
   2. The short run supply curve is upward
      sloping, the long run supply curve is horizontal (perfectly elastic) and the
      demand curve is downwards sloping from left to right.
   3. The short run supply curve is
      vertically, the long run supply curve is horizontal (perfectly elastic) and the
      demand curve is upward sloping from left to right.

 (Correct Answer is B)

1.  Which statement best describes the ‘Economic Effects of Taxes’?
   1. The equilibrium quantity does not
      change due to taxes on either party, but consumers will pay less if the tax is
      imposed only on producers.
   2. The equilibrium quantity will
      decrease, price to consumer will be raised and revenue to producers will be
      reduced, regardless of whether the tax is imposed on consumers or producers.
   3. The equilibrium quantity will
      decrease and price to consumer will be raised, however revenue to producers
      will not be reduced if the tax is imposed only on consumers.

 (Correct Answer is B)

1. ‘Supply
   Elasticity’ concepts are best described by which of the following
   statements?
   1. Like ‘Demand’, ‘Supply’ is also more
      elastic in the long run since all variables can be adjusted in the long run.
   2. ‘Supply’ will be more inelastic if
      several substitutes are available as resource inputs to the production process.
   3. ‘Momentary Supply’ is the most
      inelastic since quantity supplied can be varied in a moment.

 (Correct Answer is A)

1. Consider the implications of ‘Price Elasticity of Demand on Total Revenue’.
   Which statement below for a straight line demand curve is most accurate?
   1. In the inelastic region of the demand
      curve, lowering prices will always increase total revenue since consumers buy
      more units at lower prices.
   2. In the elastic region of the demand
      curve, lowering prices will reduce total revenue since consumers will perceive
      lower prices to mean lower quality, and buy less.
   3. In the elastic region of the demand curve,
      lowering prices will increase total revenue up to the mid-point. Further price
      reductions into the inelastic region will begin to reduce total revenue.

 (Correct Answer is C)

1. An ‘Oligopoly’entails;
   1.  High entry and exit barriers, few firms,
      undifferentiated products and adherence to the free market mechanism.
   2. Collusion to create low entry and exit
      barriers, a large number of firms, differentiated or undifferentiated products
      and adherence to the free market mechanism.
   3. High entry and exit barriers, few
      firms, differentiated or undifferentiated products and collusion for fixing
      prices and output.

(Correct Answer is C)

1. ‘Allocative Efficiency’ is based on the allocation of resources to the production of
   various goods and services;
   1. On the basis of personal interests of
      the various producers operating in the economy, achieving a balance between the
      economic interests of producers.
   2. On the basis of social interests,
      such that more units of a particular good cannot be produced without
      sacrificing another good that is more highly valued by consumers. A balance is
      achieved such that a consumer cannot be made better off without making someone
      else worse off.
   3. On the basis of social and economic
      interests of the political forces that can influence the economic decisions of
      businesses.

(Correct
Answer is B)

1. ‘Short Run Labour Productivity Measures’include;
   1. Only ‘Average Product’ and ‘Total
      Product of Labour’; and ‘Total Product of Labour’ is an indicator of the
      labour’s productivity level.
   2. Only ‘Average Product’ and ‘Marginal
      Product of Labour’; and ‘Marginal Product of Labour’ is an indicator of the
      labour’s productivity level.
   3. ‘Average Product’, ‘Marginal Product’
      and ‘Total Product of Labour’; and ‘Average Product’ of labour is an indicator
      of the labour’s productivity level.

(Correct Answer is B)

1. Three analysts have slightly
   different views regarding the ‘Statutory
   and Actual Incidence of Tax’. Circle the most accurate analyst’s statement;
   1. Seemab: The relative elasticity of
      buyers versus suppliers determines the actual incidence of tax. The more
      inelastic party will bear a greater actual tax incidence regardless of whom the
      statutory tax is imposed upon.
   2. Wendy: A Statutory tax on consumers
      rather than producers will mean that consumers will inevitably have to bear a
      greater actual tax incidence.
   3. Raymond: The more elastic party will
      bear the greater actual tax incidence regardless of whom the statutory tax is
      imposed upon. Since usually, demand is more elastic, consumers will bear more
      of the actual tax incidence.

(Correct Answer is A)

1. For the purpose of identifying if
   products are Substitutes or Complements,
   which of the following statements is most accurate?
   1.  If products A and B are Complements, their
      ‘Cross Price Elasticity’ will be greater than zero and their ‘Price Elasticity
      of Demand’ will be equal.
   2. If products A and B are Complements,
      both will have the same ‘Price Elasticity of Demand’ and if the products are
      Substitutes, their ‘Price Elasticity of Demand’ will be different.
   3. If products A and B are Substitutes,
      their ‘Cross Price Elasticity of Demand’ will be greater than zero.

(Correct Answer is C)

1.  Consider a graphical depiction of ‘Short Run Labour Productivity Measures’.
   If Average Product and Marginal Product are plotted against an x-axis scale
   which reads ‘quantity of workers per day’ and a y-axis scale which reads
   ‘output per day’, in that case;
   1. Marginal Product and Average Product
      curves would never be touching each other because of the x-axis and y-axis
      scales used.
   2. Marginal Product and Average Product
      curves would be touching each other at the point where the Average Product
      curve is at its highest point against the vertical axis.
   3. Marginal Product and Average Product
      curves would touch each other in the region where the Marginal Product curve is
      still rising and the Average Product curve is not at its peak.

(Correct Answer is B)

1. Three analysts express their views
   about the ‘Shape of the Demand curve and
   its Elasticity’. Identify the analyst making the most accurate statement;
   1. Rotimi: If the demand curve is
      vertical, we can say that demand is perfectly inelastic and the quantity demanded
      will not change at any price level. Elasticity will be zero.
   2. Radcliffe: If the demand curve is
      horizontal, then the demand is perfectly elastic. Elasticity will be infinite.
      In fact this is true for a straight line, downward sloping demand curve as well.
   3. Shariq: If the demand is depicted as
      downward sloping, and is a straight line, in that case it will have constant
      elasticity at every point on the line since slope is conceptually similar to
      the formula used for calculating elasticity.

(Correct Answer is A)

1. Regarding ‘Business Incorporation’options, which statement is most accurate?
   1. An individual may incorporate the
      business as a ‘Sole Proprietorship’, in his individual capacity only.
   2. An individual may incorporate as a
      ‘Sole Proprietorship’ or as a ‘Partnership’ with others. No other incorporation
      status will be allowed to an individual.
   3. An individual may incorporate as a
      ‘Sole Proprietorship’ individually, as a ‘Partnership’ along with others as
      well as incorporate as a ‘Corporation’.

(Correct Answer is C)

1. In the case of two products, A and B,
   price is changed by 30%. If the percentage change in quantity demanded as a
   result of the price change is observed to be 40% for A and 20% for B. Using
   this information select the best description about their ‘Price Elasticity of Demand’;
   1. The demand for both A and B, has
      similar price elasticity since the price change is set to be equal for both at
      30%. However their elasticity with respect to quantity is obviously different.
   2. The demand for A is inelastic but the
      demand for B is elastic.
   3. The demand for A is elastic but the
      demand for B is inelastic.

(Correct Answer is C)

1. “As more of a variable input is added
   to a fixed input, the Marginal Product of the variable input eventually
   decreases, which is described in economics as the phenomenon of diminishing
   returns”. Which of the statements below offers the most accurate description of
   labour productivity measures when ‘Diminishing
   Returns’are observed?
   1. The total product curve will begin to
      flatten out, the marginal product curve will fall and the average product curve
      will also turn downwards, but subsequent to the decline of the marginal product
      curve.
   2. The total product curve will begin to
      flatten out, the average product curve will fall and the marginal product curve
      will also turn downwards, but subsequent to the decline of the average product
      curve.
   3. All three curves will stop rising and
      begin to flatten out simultaneously when diminishing returns set in.

(Correct Answer is A)

1. In considering the market action, we
   can say that ‘Market Equilibrium’
   will be observed at the intersection of the ;
   1. Market demand curve and the market
      supply curve.
   2. Market demand curve and the short run
      market supply curve.
   3. Market demand curve and the long run
      market supply curve.

(Correct Answer is B)

1. From the perspective of an ‘Individual Producer’, which statement
   is most accurate?
   1. The individual producer’s MC is
      always equal to the aggregate MB of all consumers; hence there will be no
      producer surplus for an individual producer if he wishes to receive the market
      price.
   2. The individual producer will receive
      the prevailing market price and produce a quantity at which his own MC is less
      than or equal to the market price.
   3. The market price received by the
      individual producer will be based on the intersection of producer’s own MC
      curve and the MB curve of the individual consumer transacting with him. This is
      because individual producers always engage in perfect price discrimination.

(Correct Answer is B)

1. A ‘Minimum Wage’is;
   1. Like a price ceiling and is placed
      below the equilibrium wage level.
   2. Like a price ceiling or a price floor
      depending on if it is placed above or below the equilibrium wage level.
   3. Like a price floor and is set above
      the equilibrium wage level.

(Correct Answer is B)

1. The ‘Principal-Agent’problem, arises in the context of;
   1. Command-based systems
   2. Incentive-based systems
   3. Both incentive based systems and
      command-based systems.

(Correct Answer is B)

1. ‘Incentive Systems’ represent a method of organising the production of goods and services
   through;
   1. Incentives that are designed in order
      to align the activities of the employees with the profit maximising objectives
      of the firm.
   2. A structure that creates incentives
      such as promotions in order to induce employees to follow the commands, as well
      as dis-incentives through accountability systems and job loss if commands are
      not executed properly.
   3. A structure that creates positive
      incentives only. Direct negative incentives are avoided in most cases since
      strict negative outcomes are built into the system if an employee does not
      follow the directives of his seniors.

(Correct Answer is A)

1. Choose the most accurate of the three
   statements made by a company’s analysts regarding a ‘Production Quota’;
   1. Ayuna: A production quota is only
      relevant when placed to the left of the equilibrium output level. Output is
      reduced through this intervention.
   2. Rania: A production quota is commonly
      placed at the equilibrium output level and it merely serves to allocate the
      quota fairly among various producers. Total output is unaffected by a
      production quota.
   3. Cynthia: A production quota can be
      used to reduce output, keep it constant or increase output, and hence it can be
      placed at the equilibrium output level or to its left or right.

(Correct Answer is A)

1. The effects of a ‘Subsidy on Agricultural Output’are;
• To lower the price paid by consumers,
  lower the cost incurred by the producers, increase output and reduce
  dead-weight losses.
• To lower the costs incurred by the
  producers such that output may increase and consumers end up paying a lower
  price.
• To lower the price paid by the
  consumer by the exact amount of the subsidy given.

Purchase the latest curriculum for the exam from our CFA Level 1 Products Page. The economics course for 2012 has been vastly modified and the old textbook written by Michael Parking has been replaced by a new textbook.

Bond Indentures:

The bond indenture is the agreement in which all the rights of the bondholder as well as all the obligations related to the debt, on the part of the issuer, are documented in detail.

Affirmative Covenants:

These provide  details of activities that the issuer (borrower) must perform; such as paying taxes, maintaining property as collateral, paying interest and principal on a
timely basis and periodically reporting compliance to the Trustee.

Negative Covenants:

These provide details of restrictions on the issuer (borrower). Negative Covenants may include; restrictions on further borrowings, limits on dividend payments, restrictions on sale of assets and on purchase of own stock (Treasury Stock).

Basic Features of a Bond:

The Maturity of a bond is the term after which the bond is retired or paid back.

Par Value is the sum of money that will be repaid by the borrower at the end of the maturity term of the bond. The Par Value of the bond is fixed at the start. At any given time, the bond may be trading at, above or below its par value. However, at retirement of the bond, it is the Par Value that will be repaid to extinguish the debt.

The Coupon rate stated for the bond is the percentage rate of interest that will be paid by the issuer (borrower), to the bondholder (lender), on a periodic basis. In the U.S., the coupon payments are made semi-annually.

Bonds without Coupons:

Zero Coupon Bonds are bonds that do not have stated coupon rate. These are issued at a deep discount to their par value.

Accrual Bonds are another kind of bonds that do not have a coupon payment during the period these remain outstanding. However, all interest that
is due to the lender (bondholder) is accrued and paid along with the principal, at Maturity.

Bonds with Coupons:

Step-Up Notes have a low initial coupon, which increases once or more as a ‘Step-Up’ function.

Deferred-Coupon Bonds the interest payments are deferred for an initial period, called a ‘Deferred Period’. At the end of this time, the bond
begins to make regular, periodic payments to the bondholder.

Floating-Rate Bonds are also called variable rate securities; these bonds have coupon rates that are re-set periodically in relation to the changes in an
agreed reference rate. For example; Coupon Rate = LIBOR + Quoted Margin.

Mechanics of a Floating Rate Bond:

Once the coupon rate on a floater has been Re-Set, the new rate is paid at the end of the subsequent coupon period. Floating rate bonds may have a ‘Cap’ or a ‘Floor’ which determine the maximum or minimum values that the coupon rate can take on at any given time, in order to restrict the maximum and minimum limits for the coupon rate. Floating rate bonds may have a fixed or a variable quoted margin, which is added on top of the Reference Rate.

Accrued Interest on Bonds:

In order to separately account for the accrued interest on the bond, the price of the bond is expressed in two different ways; firstly with the accrued interest included in it, which is called ‘Full Price’ or ‘Dirty Price’. Alternatively the bond’s price without the accrued interest is referred to as the ‘Clean Price’ or simply ‘Price’.

Methods through which Bonds are paid off by the Issuer:

There are several methods according to which a bond is retired. The issuer can make the final principal repayment in a single lump sum, or the principal may be paid in partial repayments periodically.

Embedded Options:

Certain embedded options in bonds extend rights to the bondholders. These rights could include; a ‘Put Option’ or a ‘Conversion Option’. The presence of embedded options can create challenges in the valuation of bonds since the cash flows related to the bond cannot be forecasted with accuracy due to the possibility of exercise of an embedded option.

Margin Buying:

Investors can borrow funds via the brokers through who they trade in the securities markets. The investor puts a certain deposit percentage and the broker provides the rest as a loan. The broker in turn borrows these funds from the banks at a special rate called the ‘Call Money’ rate and adds a service charge.

Repurchase Agreements – REPO:

A REPO involves the sale of a security with a promise to repurchase at an agreed, higher price on a specified date. This period could be a single day ‘Overnight REPO’ or for a longer period ‘Term REPO’, the party that originally makes the sale is the borrower of capital. This party pays a higher price upon repurchase, the difference representing the cost of borrowing.

Risk Categories in Bond Investing

Interest rate risk *

Call Risk & Prepayment Risk       Reinvestment risk       Credit Risk         Liquidity risk         Exchange rate risk        Volatility risk       Inflation risk      The Yield curve risk       Event risk       Sovereign Risk

Changes in Market Interest Rates:

The interest rates prevailing in the market are constantly subject to change. For a fixed coupon bond, the attractiveness of the bond will be determined through a comparison between the bond’s coupon rate and the prevailing market interest rates at the time of issuance.

Bond’s Coupon < Market Interest Rate => Bond is Issued at Discount

Bond’s Coupon > Market Interest Rate => Bond is Issued at Premium

Bond’s Coupon = Market Interest Rate => Bond is Issued at Par

Defining Interest Rate Risk:

The fluctuation in the price of a bond in response to changes in the market’s interest rate environment is referred to as ‘Interest Rate Risk’. The Price of a bond is inversely related to the market interest rate.

Bond Features Affecting Interest Rate Risk:

Certain features of a bond instrument have an impact on the level of interest rate risk that the bond instrument will be exposed to. A longer maturity bond will have greater price sensitivity to interest rate fluctuations.  A lower coupon rate bond will have greater price sensitivity to interest rate. Accordingly, the greatest interest rate risk is involved with zero coupon bonds.  An embedded call option is valuable to the issuer. The issuer may call the bond in a falling interest rate environment. From a
bondholder’s perspective, a callable bond should be less valuable and hence should be cheaper than a regular bond.

Value of a Callable bond = Value of Regular bond – Value of Call Option

Interest Rate Risk of Floating Rate Security:

The price of a fixed income bond changes due to the fact that the market rate of interest keeps on changing whereas the bond’s own coupon rate is fixed. For a variable coupon bond, the interest rate is periodically re-set according to a coupon formula that is often linked to a market based interest rate reference. Thus the divergence between the coupon rate and the prevailing market interest rate is frequently eliminated, with every re-set of the coupon rate for an overall lower interest rate risk compared to fixed coupon bonds.

Interest Rate Risk:

The interest rate risk of a bond can be quantified and measured through the calculation of the bond’s ‘Duration’. Duration measures the price sensitivity of a bond in response to a change in the market interest rates. More specifically, Duration measures the ‘Approximate percentage change in the price of a bond in response to a 100 bps change in the market rate of interest’.

Duration =        Price of Bond when Yield Falls – Price of Bond when Yield Rises

                        2 x (Initial Price before Rates Changes) x (Change in yield in decimals)

Dollar Duration:

Dollar Duration relates closely to the Duration calculation seen earlier. Dollar Duration simply measures the ‘Approximate Dollar change in bond price in response to a 100 basis points change in yield’.

     Dollar Duration = (Duration x Dollar Value of Bond) / 100

Yield Curve:

The Yield Curve is a plot of interest rates of similar credit-quality bonds against various maturities, where the interest rates are those prevailing at a particular point in time. The interest rates are plotted on the ‘y’ axis and the maturities are plotted on the ‘x’ axis. The yield curve can be of any shape.

Duration of a Portfolio of Bond:

The Duration of a single bond provides us an interest rate risk measure. The Duration of a bond portfolio will be the weighted average duration of the individual bonds comprising the portfolio. Furthermore, a bond portfolio will contain several bonds of different maturities.The Duration measure assumes that the underlying change in interest rates will be a parallel shift of the yield curve, which implies that the interest rate should have changed equally for all maturities. This is a simplifying assumption, where in reality; the yield curve may shift in any manner, including non-parallel type moves.

Yield Curve Risk:

Based on the component weightings of different maturity bonds held in a portfolio, each portfolio will have a unique exposure to changes in the yield curve, which cannot be accounted for simply through using Duration. This risk related to yield curve changes and its impact on the overall value of the bond portfolio comprising of various maturities, is referred to as ‘Yield Curve Risk’.

Callable Bond:

A callable bond has a call option embedded in it. The call option allows the issuer (borrower) to redeem or call back the bond prior to maturity. The issuer is likely to call the bond back early in the event that market interest rates decline to a level that is significantly lower than the stated coupon rate of the bond.

Disadvantages of a Callable Bond, for the Investor (Bondholder)

• Reinvestment Risk in a Falling Interest Rate Scenario:
  From the perspective of the bondholder, the exercise of the call option by the issuer, in a falling interest rate environment implies that the bondholder (investor) will ave to reinvest the returned principal at lower prevailing rates.
• Cash-Flow Uncertainty: The pattern of cash flows will not be known with certainty by the bondholder, for a callable bond.
• Reduced Price Appreciation: When interest rates fall, the price of a regular bond increases. For a callable bond, falling interest rates also increase the prospect of the bond being recalled; therefore the price of the callable bond will not increase as much that of a regular bond (Called Price Compression).

Pre-Payable Bond e.g. Mortgage Backed Security:

A mortgage backed security is a bond that is based on a pool of home mortgages. As an investor, the holder of the mortgage backed security is the lender of the capital, whereas the homeowners belonging to the mortgage pool are the borrowers.

Disadvantages of a Pre-payable Security for the Investor (Bondholder)

The same disadvantages apply to pre-payable securities as applied to the callable securities.

Reinvestment Risk in Amortizing Security:

In the case of an amortizing security, in which coupon and principal are paid monthly, the cash flows received have to be reinvested at the prevailing market rates. Therefore reinvestment risk is significant for amortizing securities such as Mortgage Securities, since investment decisions will have to be successfully executed each time a payment is received. This is more frequent for an amortizing security compared to a regular bond; hence reinvestment risk is higher for amortizing securities. On the other hand, a zero coupon bond carries no reinvestment risk.

Credit Risk:

Credit Risk exists due to the risk of default, the risk of the credit spread changing, and the risk that the security may be downgraded.

Liquidity Risk:

Dealer interest in a security changes over time, as other, more attractive issues come to market. This results in a widening of bid-ask spreads and changes in liquidity risk.

Exchange Rate and Inflation Risk:

When investors purchase bonds that are denominated in another currency, the investors face exchange rate risk. This is the risk that the foreign currency, in which the bond is denominated, and in which it makes coupon payments may depreciate relative to the investor’s domestic currency. A depreciation of the foreign currency implies that the coupon proceeds and the ultimate principal repayment will translated into a fewer units of the investor’s domestic currency. When investors purchase bonds in their local currency, they face inflation risk. This implies that the investor could suffer a loss of purchasing power due to Inflation, when he receives the coupon proceeds and the principal repayment.

Yield Volatility and Bonds with Embedded Options:

Price of a Callable Bond = Price of a Regular Bond – Price of Call Option

Price of a Put-able Bond = Price of Regular Bond + Price of Put Option

Callable Bonds:

When expected yield volatility increases, the value of the call option will increase and the Price of the callable bond will decrease (since the price of the call option is subtracted).

Put-able Bonds:

An increase in the expected yield volatility will increase the price of the put option, which will cause an increase in the price of the put-able bond (since the price of the put option is added).

Event Risk:

Event Risk is the result of natural disasters, regulatory changes and corporate takeover and merger activity that may impair the issuer’s ability to make regular payments on their bonds. Alternatively, these events may increase the inherent risk in the issuer’s operations which may increase the yield required by investors from these instruments.

Sovereign Risk:

Sovereign Risk is the risk faced by an investor when he purchases the government bonds of a foreign government. The foreign government may default on its debt or it may take actions or suffer economic outcomes due to which the credit quality of its sovereign debt may increase. This would cause the sovereign risk spread to increase significantly and the government bonds would suffer an adverse price impact.

Credit Risk of Government Securities:

The debt issued by national governments is referred to as Sovereign Debt, which is often the largest sector of the bond market in any country. Bonds that are issued by the US government are considered by the market to contain no credit risk. The debt of national governments may be denominated in their own domestic currency or it may be denominated in a foreign currency. For any national government, the likelihood that the national government will default on its local currency bond obligations, will be virtually nil, since any government has the mechanisms for raising local currency tax revenue and even the ability to print more of the local currency. Different countries will have different sovereign ratings, which will are affected by the country’s economic prospects.

Four Methods for Auctioning Sovereign Bonds:

Regular Cycle – Single Price: Regularly bringing new sovereign bonds issues to the market. The government will select the lowest yield bid that has come forward (which corresponds to the highest price for the bond issue), and sell the entire issue at that single price to all bidders. Used in the U.S.

Regular Cycle – Multiple Price: This auction is a regularly held auction for new bond issues; however the bonds are issued at the various price levels to the different bidders corresponding to the prices they have bid.

Ad-Hoc Auction Cycle: This auction mechanism is used by a government for any new ad-hoc issues it may plan to bring to the market at opportune economic times, or based on its need for funds. Used by the Bank of England.

Tap Method: For issuing new bonds of an existing issue. The government issues the new bonds identical in characteristics to an existing issue, as and when the need arises. Used in the UK, the US and the Netherlands.

Securities Issued by the U.S. Treasury:

Fixed Principal U.S. Treasury Securities:

T-Bills are a treasury security with maturities less than 12 months. The three maturities for T-Bills are 1 month, 3 months and 6 months. T-Bills are
pure discount instruments. Treasury Notes are coupon paying securities with maturities of 2, 3, 5 and 10 years. Treasury Notes pay semi-annual coupon, and are initially issued at a price that is close to their Par Value. Treasury Bonds have original maturities exceeding 10 years, and are usually of 20 or 30 year maturity. Coupon is paid semi-annually. T-Bond and T-Note trading prices are quoted as a percentage of Par Values, along with a fraction of 32.

TIPS:

Treasury Inflation Protected Securities are a ‘Variable Principal’ instrument issued by the U.S Treasury. The coupon rate for the TIPS is set at a fixed level determined through the auction process. Subsequently, the Par Value, or the principal amount to be repaid at maturity, is adjusted semi-annually in relation to the inflation rate, as measured by the Consumer Price Index, particularly, the CPI-U, which is the CPI for all Urban Consumers. TIPS pay semi-annual coupon.

Demand for Longer Maturity Zero Coupon Bonds:

The U.S Treasury only issues Zero Coupon Treasury-Bills, T-Bills, which have a maturity less than 1 year. However, the Treasury does not issue zero coupon Treasury Notes or Treasury Bonds. There is however a demand for zero coupon instruments with maturities longer than one year. The private sector thus created such securities by decomposing the coupon payments and the principal payments of Coupon-Paying Treasury Notes and Coupon-Paying Treasury Bonds, which are then sold as zero coupon securities. A 3 year 6% coupon, semi-annual, $1000 par value Treasury instrument can be decomposed into 6 coupon strips of $30 each and 1 principal strip of $1000.

On-the-Run and Off-the-Run Treasury Securities:

On-the-Run securities are Treasury issues that have been brought to the market most recently. Generally, the level of interest and liquidity of on-the-run issues is higher. Because of higher liquidity, on the run issues are slightly more expensive in trading. On the run treasury yields are used in developing the par yield curve, which will be explained later. Off-the-Run Treasury Securities are treasury securities previously issued, and for similar maturities as these issues, a new bond issue has also been brought to market. Trading volume and interest is generally lower in off-the-run issues.

Federal Agency Securities:

The national government has the authority to establish subordinate agencies for the purpose of issuing bonds. The bonds issued by these agencies may carry the direct guarantee, or the implied guarantee of the government. Bonds issued by these agencies are referred to as ‘Federal Agency Securities’.

Federally Related Institutions:

These institutions are considered to be semi-government organizations which function as an arm of the federal government, e.g. Government National Mortgage Association ‘Ginnie-Mae’. The securities issued by Federally Related Institutions are considered to be free of Credit Risk since these are backed by the full faith and credit of the federal
government itself.

Government Sponsored Enterprises – GSEs:

These are privately owned entities that operate under a Public Charter. The GSEs include most prominently; Federal National Mortgage Association ‘Fannie-Mae’ and Federal Home Loan Mortgage Corporation ‘Freddie-Mac’. The bond issues of GSEs are not backed by the full faith and credit of the government and are subject to credit risk and default.

Mortgage Backed Securities ‘MBS’:

Mortgage Backed Securities are bonds for which the underlying collateral for the loan is a pool of home mortgage loans. The cash flows from a home mortgage loan are different from the cash flows of a regular coupon paying bond as these include scheduled and un-scheduled principal pre-payments. There are three main types of mortgage backed securities: Mortgage Pass-through Securities, Collateralized Mortgage Obligations and Stripped Mortgage Backed Securities.

Mortgage Pass-through Securities:

Different lenders have lent money to the home owners as mortgage loans. These loans are purchased and pooled by government agencies to create a pool of such mortgage loans. Every month, as home owners make payments of interest along with principal payments, including early principal pay-downs, the cash-flows are routed to the investors in proportion to the ownership share of the pool that their securities represents. When interest rates fall, home-owners tend to re-finance their mortgages (paying off the old mortgage which was in the pool), which implies that pre-payment risk increases in a falling interest rate scenario. All holders of a mortgage pass-through security
are equally exposed to pre-payment risk.

Collateralized Mortgage Obligation ‘CMO’:

In a CMO security, different tranches of cash flows are created from the underlying pool such that holders of any tranche of the CMO will receive the regular interest payments pro-rata to their investment, however all principal payments (scheduled and unscheduled) are allocated sequentially to the various tranches. Only after the principal due to the first trance has been fully paid from the principal amounts received in the pool, the next lower tranches begins to receive the principal payments. The highest tranche is thus exposed to the greatest pre-payment risk whereas the pre-payment risk is lower as we move down the various tranches. Thus pre-payment risk partitioning and redistribution is the primary motivation for the creation of Collateralized Mortgage Obligations.

Stripped Mortgage Backed Securities:

These securities are created by separating the interest payments and principal payments (including early principal pay-downs) of a pool of mortgages. The securities created from the interest cash-flows of the property owner’s mortgage payments are called ‘Interest Only Strips’. Securities created from the principal payment component of the home owner’s mortgage payments are called ‘Principal Only Strips’.  Only the principal payments are subject to Pre-Payment Risk.

Municipal Securities:

Within the U.S, state and local governments issue Municipal Securities, including the various counties, school districts, water boards etc. Municipal Securities expose investors to Credit Risk. Municipal Securities are often referred to as Tax-Exempt securities. This refers the fact that Interest income from Municipal Securities is tax exempt at the federal level; however, individual state taxes may apply on the interest income according to the legislation prevalent in a particular state. Capital Gains from Municipal Securities are taxable.

Municipal Tax Backed Debt:

Such bonds are issued by school districts, counties, towns, and states. The bonds are backed by the full faith and taxing power of the issuer. Tax-Backed debt includes General Obligation bonds, Moral Obligation bonds, and obligations supported through Public Credit Enhancement programs, which are supported through binding and legally enforceable credit quality enhancement guarantees provided either by a state or a federal agency. These bonds are frequently used for funding school districts.

Municipal Revenue Bonds:

These bonds are backed by the Revenues generated from specific projects. These bond issues are used for funding of revenue-generating or public infrastructure projects such as transportation, housing, healthcare, ports, and sports facilities. The issuance of these bonds does not require the specific approval of the voters, as they fall outside the General Obligation ‘GO’ debt limits. Some bonds may be backed through a pledge of funds from the General Fund as well.

Corporate Funding:

Corporations may raise debt capital either through banks and financial institutions or through the issuance of debt securities. The market for corporate debt securities in most countries is fairly small and undeveloped. Large Corporations however have the ability to raise capital through issuance of debt securities in their domestic market as well as from international markets. Bondholders of a corporation have a superior claim over equity shareholders of the corporation, in the event of bankruptcy.

Credit-Rating Agencies:

Credit Rating Agencies assign ratings to corporate bond issued based on an assessment of default. Credit ratings can be assigned to the Corporate Entity or to a particular bond obligation, and the two ratings may not be the same, as it is entirely possible that a particular bond issue possesses a different risk profile relative to the entity bringing forth the issue. Broadly, the agencies consider the following elements in assigning a credit rating, which have commonly come to be known as the 4 C’s of Credit: Character, Capacity, Collateral and Covenants.

Corporate Debt – Corporate Bonds:

These are fixed coupon bonds that pay regular coupon periodically and principal is repaid at maturity. Corporate bonds may be secured or unsecured. Secured bonds have an underlying pledge of collateral of physical assets or through a pledge of financial assets such as share certificates. Bonds that are secured through financial assets held by the company are referred to as Collateral Trust Bonds. Unsecured bonds have no such underlying collateral, and are referred to as Debentures. Holders of debentures however do have a claim against the general pool of the company’s assets. Some corporate bonds are issued with a Credit Enhancements, as part of which an additional third party guarantee is made available for the enhancement of the credit quality of the issue.

Corporate Debt – Medium Term Notes ‘MTNs’:

MTNs are a fairly unique and extremely flexible mechanism for enabling corporations, agencies and national governments, to raise debt capital. By registering an MTN issue with the Securities and Exchange Commission ‘SEC’ under ‘Shelf Registration’ Rule 145, a Corporate entity may continuously bring to market; bonds issues of various maturities. In a Structured MTNs an issuer of an MTN may enters a transaction in the derivatives market and utilize the cash flows from the derivative instrument to create the cash flow pattern of the MTN issue. This way, an issuer may structure the MTN to possess the characteristics of some other derivative instrument rather than remaining a pure and simple debt instrument.

Corporate Debt – Commercial Paper:

These are short term promissory notes issued by Corporations that have high credit ratings. There is no stated coupon on promissory notes and maturities are typically shorter than 270 days. Holders of commercial paper are generally paid off from the issuance of new commercial paper by the issuer. Commercial paper can be directly placed in the market or it can be placed through dealers, Dealer-placed paper. In Directly-placed paper there is no intermediary between the issuer and the investors.

Funding Requirements of Banks:

Banks are themselves large corporations that have funding requirements of their own. Banks will use the various debt instruments that are available to all corporations for raising debt capital. Additionally, banks raise funds through; 1) Negotiable Certificates of Deposit and through 2) Bankers Acceptances.

Negotiable Certificates of Deposit:

A certificate of deposit ‘CD’ is issued by a bank against a deposit made by an investor into the bank. A certificate of deposit is issued for a fixed denomination, carries a fixed interest rate as well as bears a maturity date. A CD may be non-negotiable or negotiable. For the Non-Negotiable CDs, the investor cannot transact the CD in the open market as financial instrument and must wait till the maturity of the CD. A Negotiable CD on the other hand can be traded in the open market with a usual denomination of $1 million.

Bankers Acceptances:

This instrument serves the purpose of international trade settlement between exporters and importers. At both ends, a financial institution is involved; the exporter’s bank and the importer’s bank.

Asset Backed Securities:

Securitization is a process under which a group of credit card loans, customer receivables or auto loans may be packaged to create an interest-bearing security backed by the
cash flows of the loans. An ABS issue is backed by the collateral of the underlying cash flows of the loan portfolio. The motivations from the lender’s perspective are to turn an illiquid loan portfolio into a liquid investment.

SPV for an ABS:

Since the ABS issue is interest bearing, the issuer is concerned with obtaining the funds at the lowest possible interest rate. This requires that the ABS issue should be assigned a high credit rating. To achieve a high credit rating for an ABS issue, the mechanism of a Special Purpose Vehicle ‘SPV’ is used. An SPV is a separate legal entity that can be created specifically for this purpose. The loan portfolio is sold to this SPV and since the SPV is a separate legal entity, the existing creditors of the car company will not be able to claim the cash-flows from the car loans in the event of a bankruptcy. The SPV is thus a bankruptcy remote entity, and the ABS issue can achieve a higher credit rating compared to the corporate credit rating, at lower interest rates. The company can further achieve external or internal credit enhancements.

Collateralized Debt Obligation:

A CDO is a special category of asset backed securities where the CDO is backed by a diversified asset pool. The asset types include domestic and international bonds, bank loans, residential and commercial mortgages, bonds of various yield grades, as well as other CDOs. A CDO backed by a pool of various bond obligations is referred to as a ‘CBO’ i.e. A Collateralized Bond Obligation. When a CDO is backed by a pool of various bank loans, it is referred to as a ‘CLO’, i.e. A Collateralized
Loan Obligation.

Primary Market for Sale of New Bonds Issues:

New bond issues are placed with public investors through the primary markets. Most commonly, bond issues are underwritten by an investment bank on the basis of either a firm commitment, or a best effort basis. Bonds are also underwritten via a ‘Bought Deal’ or an ‘Auction Process’. Bonds can also be privately placed with a small group of
institutional investors under rule 144A in the U.S., when an investment bank is involved and under non-Rule 144A for traditional private placement.

Secondary Market for Subsequent Trading:

Subsequent to the issuance of bonds, trading between investors takes place primarily in the OTC, Over the Counter market. In the OTC market, dealers quoted bid ask spreads. Dealers own capital is tied up in this market-making process as dealers buy and sell from their own inventory. Increasing capital requirements, lower margins and higher risk in bond trading due to volatility in bond prices, the trend in trading mechanism is shifting towards the Electronic Trading Platforms. Electronic trading can be through a Single-Dealer System, which is simply an electronic version of the conventional OTC trading, or through a Multi-Dealer System.

Interest Rate Policy Tools:

The Federal Reserve implements Monetary Policy through the following interest rate policy tools. Most frequently, the Fed employs Open Market Operations and Discount Rate determination to implement its monetary policy. Open market operations are used to affect the Federal Funds Rate. This is the rate for interbank borrowing and lending. When the Fed sells Treasury securities, the effect is that funds are withdrawn from the market and the resultant scarcity of capital raises interest rates. The purchase of Treasury Securities in the open market increases the supply of funds in the market which lowers interest rates. The Discount Rate refers to the interest rate at which banks can borrow funds from the Fed’s discount window. Increasing the discount rate raises the cost of funding for the banks thereby raising interest rates. Further, banks are required to maintain a mandatory level of funds as reserve that the banks cannot lend out. Increasing the reserve requirement creates scarcity of funds in the market and raises interest rates. Federal Reserve can also use Verbal Persuasion to convince banks to lend more or less.

Various Shapes of the Yield Curve:

As stated earlier, the normal shape of the yield curve is upward sloping, indicating higher interest rates for longer maturities compared to shorter maturities. The yield curve could also be downward sloping, flat or humped.

Theories of Term Structure:

According to the Pure Expectations Theory, long term rates are a function of the short term rates that are likely to be prevailing at a future point in time. Any shape of the yield curve can be explained through this theory based on expectations. According to the Liquidity Preference Theory, since longer term bonds have lower
liquidity than shorter term bonds, investors require an additional risk premium to compensate them for the lower liquidity and the yield curve is likely to be
upward sloping. If however expectations are that short term rates will fall significantly in the future, it is possible that the yield curve may still be downwards sloping. Any shape of the yield curve may be explained by this theory. The Market Segmentations Theory states that different investor groups have different maturity sector preferences. All yield curve shapes are consistent with this theory as well. A modification of the market segmentation theory, the Preferred Habitat theory states that investors move slightly out of their maturity preference ranges, induced by preferential yields in a segment adjacent to their own preferred maturity habitat.

Conventional Valuation Method for a Bond:

A bond’s intrinsic value is determined by computing the present value of its future cash flow. A single discount rate is used to discount the various cash flows of the bond to present time.

Bond Valuation using Spot Rates:

In view of the yield curve however, the interest rates relevant for different maturities will not be the same. It would therefore be more appropriate to discount the various cash flows using the particular discount rate relevant to each maturity. The appropriate discounts rates to use for each maturity are called the spot rates for the maturity

Absolute Yield Spread:

Absolute Yield Spread is also called the Nominal Spread. This measure is calculated as the simple difference in the yield between two bonds expressed in basis points.

Relative Yield Spread:

The Relative Yield Spread simply expresses the nominal difference in yields as a percentage of the yield level of the lower yield.

Yield Ratio:

This is simply, the yield of the higher yielding bond, divided by the yield of the lower yielding bond.

Credit Spread:

This is the difference in yields between two bonds which is solely due to the difference between their credit qualities. A credit spread can be calculated between a corporate bond and a treasury security’s yield. Similarly a credit spread could exist between two corporate bonds due to the difference between their credit rating.

Economic Signals:

Credit spreads provide signals regarding the state of the economy. The credit spread between corporate bonds and treasuries will decrease during economic booms. On the other hand, recessionary periods will increase the inherent risk of corporate initiatives which will translate into a higher yield requirement from corporate bonds. This will increase the credit spread between corporate bonds and treasuries during recessions.

Yield Spreads of Bonds with Embedded Call Options:

For bonds with embedded call options, the bondholder is exposed to three additional risks; upward price compression, cash flow uncertainty and reinvestment risk. Thus the yield spread of a bond with an embedded call option will be higher relative to a benchmark yield, due to the call option.

Yield Spreads of Bonds with Embedded Put Options:

For bonds with embedded put options, the bondholder effectively has lower risk since the bondholder owns the Put option which can be exercised if interest rates rise. Thus the yield spread of a bond with an embedded put option, will be lower relative to the benchmark yield.

Yields of Larger Issues:

In general, larger issues are more liquid than smaller issues. Larger issues will be in greater demand, due to their higher liquidity which will mean that these will be more expensive, and the resultant yields will be lower relative to a benchmark treasury yield.

Yields of Smaller Issues:

For smaller bond issues liquidity will be lower, consequently the level of risk will be higher due to the lower liquidity. This will imply a lower price for smaller issues, translating into a higher yield relative to a benchmark treasury yield.

After-Tax Yield on Taxable Bonds:

For any investor the yield earned on a taxable bond will be effectively reduced after the investor has paid taxes on income earned from the bond. The Marginal Tax rate relevant to the investor will determine how much the investor will be left with, after paying taxes. The after tax yield to the investor will be given as:

After Tax Yield = The Yield on the Taxable Bond x ( 1 – Marginal Tax Rate)

Yield on Tax Exempt Bonds:

Certain bonds are tax exempt and the investor does not become liable to pay taxes from the income earned through such bonds. As a result, tax exempt bonds will generally offer lower yields due to the tax benefit. In order to draw a comparison between this yield and the yield of a taxable bond, the tax equivalent yield will be calculated.

 Taxable Equivalent Yield = Yield on Tax Free Bond / ( 1 – Marginal Tax Rate)

Funded Investor:

A funded investor borrows funds for the purpose of investing in various securities. LIBOR is the interbank borrowing rate, and other investors pay a mark-up over that. The cost of borrowing for a funded investor can be determined based on the spread that he is charged over LIBOR to be added on to the base rate.

End of Quick Review

The ‘CFA®’ Global designation is the gold standard qualification in investment management. The CFA ® Program of study is offered by CFA Institute and the qualification has gained unsurpassed acceptance and recognition all over the world, including Singapore.

The CFA® charter is awarded upon successfully passing three, progressively difficult exams, and upon demonstrating relevant work experience. Each level of the CFA® Exam requires 300 hours of study and rigorous preparation. While the program is designed for self study, it has recently gained more of a taught focus in several training establishments as well as universities across the world.

In order to study for this exam, students require access to the prescribed curriculum textbooks of CFA Institute. Exam prep providers, including Finance Grid, UK, provide study notes, exam tutorials and formula sheets. You can access the complete student pack in digital format, for the CFA® Level I Exam at www.finance-grid.com and start your CFA® study today. You will also have to register as an exam candidate with CFA Institute.

In the UK, the CFA® Qualification is considered equivalent to a Masters level qualification.

Visit Finance Grid for the latest student pack, for the December 2011 CFA® Level I Exam, in Singapore.

CFA® Level I – Exam Preparation Essential Pack – Singapore:

1. CFA® Tutorial Presentations; these are presentations designed in Power-Point and rendered in ‘Flash’. The tutorials are available in a high quality presentation-player, which can Play, Pause and Rewind the presentation to suit your pace of study.
2. Quick Review Books; these review books contain concise summaries of all exam concepts and list as well as explain each formula required for the exam.
3. All digital content is also printable sine it is also offered in a printer friendly PDF format, which is additionally optimised for viewing on all smart phones and computers, in addition to the printer version.

The tutorials contain about 3000 slides covering the whole CFA® Level I Course for 2011, and can be used for self study as well as used for training classes. All assigned problems are illustrated as solved problems in the tutorials.

Finance Grid Ltd. UK

Get it right the first time.

Finance Grid Limited, UK

www.finance-grid.com

Study materials offered by Finance Grid consist of interactive PowerPoint presentations, allowing students to study at their own pace. Students can ‘Play’, ‘Pause’ and ‘Stop’ the study presentations to match their individual pace and schedule. Each slide transition has been placed to create the sequencing of ideas to help students learn the first time. Computational problems have been solved on a step-by-step basis and the accompanying text is in-depth to help students develop a linkage between the central idea, problem and its solution.

The PowerPoint presentations are accompanied by ‘Quick Review’ material so that the details learnt are presented in a condensed format to help achieve the cumulative learning strategy. Finance Grid has combined the study materials (PowerPoint and Quick Review PDF) into modules rather than study sessions and each module is available for sale separately.

The CFA® Designation

The CFA® designation is a highly visible and valuable credential in financial services with global recognition guaranteeing the opportunity for career advancement in investment management with several options. According to the annual report of the CFA Institute for 2010, there are 102,800 members of the CFA Institute and more than 200,700 individuals enrolled for the CFA program in 2010, which is more than double the number of registrations over 2009.

CFA Level 1 Product Brochure

CFA® Level 1 Product Brochure 2011CFA® Level 1

Finance Grid Limited, CFA® Level 1 2011 Product Brochure – Download PDF