Friday, July 31, 2009

CFA study session #2: quantitative methods: time-value


Now it begins; quantitative methods is worth the price of admission! I intend for these posts to be helpful to not only CFA candidates, but also to MBAs looking to brush up on their quant skills (aka poets). Before you go any further, however, you MUST invest in a financial calculator. I use the HP-12C (Hewlett Packer); it is one of only two calculators recognized by the CFA Institute (the other being the Texas Instruments BAII Plus). The majority of calculations will involve no more than 5 buttons that are nicely placed next to one another on the very top of the calculator:

n (number of time periods)
i (interest rate per period)
PV (present value)
PMT (payment for a series of cashflows)
FV (future value)
Mastering time-value questions helps to build the foundation for more difficult calculations, such as "internal rate of return (IRR)" and "net present value (NVP)," which are critical for classes in Finance and Private Equity.
The simplest of time-value questions might ask you "what $1,000 invested today in a CD for 5-years compounded annually at a rate of 3.00% would be worth at maturity?" All you need to do is type $1,000 (press "PV"), type 5 (press "n"), type 3 (press "i"), and then press "FV" and within seconds it will give you the correct answer of $1,159.27. Of course this problem could have been made more difficult by telling you that the interest compounds monthly (rather than annually), but this only requires the slightest of adjustments (i.e. adjust the number of periods for "n" from 5 to 60 (5x12 months) and for "i" from 3.00% to 0.25% (3/12 months).
They can also ask you the question in reverse by requiring you to choose between two payment options by calculating PV. For example, say "you won the lottery and your two options are to either receive a lump sum of $1,000,000 today, or receive $2,000,000 at the end of 10 years with a interest rate of 4.00% compounded annually over that period. Which is the better option?" Begin by figuring out the PV of the future lump sum by typing 10 (press "n"), type 4 (press "i"), and type $2,000,000 (press "FV"). Then press PV and you will discover that it is worth $1,351,128.24 in today's dollars, and therefore the better option. Of course, good luck, postponing your purchase of a Ferrari for 10 years! With practice you an easily master time-value questions. After all, I majored in Political Science (minor in Philosophy) in college and now look at me crunch out these numbers!
You can also solve for the number of periods ("n"), or interest rate ("i"), provided you are given the PV and FV, as well as a third variable. For example, you may be asked the question: "What is the yield to maturity (YTM) on a corporate bond that was bought for $980 and pays a semi-annual 5.00% dividend, which will mature in 10 years at a face value of $1,000?" To solve: type 20 (press "n" 10 year bond x 2 annual dividend payments), type -$980 (press "PV" negative sign to signify outflow), type $1,000 (press "FV positive sign to signify inflow), type $25 (press "PMT" signifies semi-annual 5% dividend inflow based on $1,000 par value). Once you've input these 4 variables, press "i" and after about 10 seconds (btw this is a harder calculation) the calculator will tell you that the answer is 2.63%, which you must then multiple by 2 to get the annual rate (after all, we were working with semi-annual payments), giving you a final YTM answer of 5.26%. Predictably, the YTM is greater than the 5.00% dividend rate, because the bond was bought at a $20 discount ($1,000 - $980), which must be included into the overall investment return. In contrast, if the bond was bought at a premium to face value, say $1,020, then the YTM would have been lower than the dividend rate. One last point, to avoid future aggravation for why your HP-12C is not processing properly, you MUST follow the convention of using the negative sign to signify cash outflows (money-out), and the positive sign to signify cash inflows (money-in). Otherwise, in the previous example, you would have seen the "ErroR" sign if you used positive signs for PV, PMT, and FV. Again, this will be critical later when accounting for cashflows when solving for "IRR" and "NPV."
Continuing with the trend of asking increasingly difficult (but solvable) questions, see if you can answer this final question: "Your oldest child is currently 22 years old and just completed their undergraduate degree, when she mentions to you, that in 6 years (after they gain some work experience) she would like to study for an MBA at Oxford University. Currently, tuition for the Oxford MBA is £31,000, and has been steadily rising at 5% per year. How much money money do they need to invest per month now to have enough money to pay for the MBA assuming an annual 9% investment return?" You must first calculate the FV of the price of tuition, by typing £31,000 (press "PV"), type 72 (press "n" 6 years x 12 months), and type 0.417% (press "i" 5.00% inflation rate divided by 12 months). The FV is £41,819.55. Now start the second calculation by storing the £41,819.55 (press "FV"), type 72 (press "n"), and type 0.75% (press "i" 9% investment rate divided by 12 months). Once you press "PMT" you will see that you need to invest £440.17 each month in today's pounds for 6 years to afford tuition at tomorrow's inflation adjusted price. Stayed tune for more MBA boot-camp!

Thursday, July 30, 2009

giving big by going small through micro-finance

Thank you everyone for helping me pass 500 hits on my blog since first starting it about 4-months ago! I try to keep things interesting and informative by primarily writing about my journey through the Oxford MBA. I've also enjoyed posting information regarding my path to the CFA (Chartered Financial Analyst) designation, which is of interest to many people working in finance. And of course, with the extra free-time I have, I volunteer by teaching financial literacy (through Operation Hope), and promoting microfinance through my Board position on the Microfinance Club of New York (MFCNY) - a 501(c)(3) nonprofit whose mission is to serve as a forum and network for all things microfinance.

Later today I'll be taking the Long Island Rail Road into NYC to attend this month's MFCNY event, featuring Elisabeth Rhyne, who will be talking about her new book entitled: "Microfinance for Bankers and Investors." This event will be held tonight at Deutsche Bank on Wall Street, beginning at 6:30pm. Generally, the MFCNY Board members (including myself) try to organize about 9 events a year, with most of us drawing from the support of our employers. For example, last year, with the help of Citi Microfinance, I was able to arrange 2 events with the Global Director of Citi Microfinance, who flew in from London to speak to our members regarding the risks facing microfinance, and on the niche role that institutions play in remitting money between countries.

I recommend anyone interested in learning more about microfinance to attend one of our events. The MFCNY lists events on their homepage: www.mfcny.org. We also work with the Microfinance Club UK and the Silicon Valley Microfinance Network for those of you who are living in either London or California. You can also find a list to some great books and publications on microfinance from Grameen, the winner of the 2006 Nobel Peace Prize. Good luck, and feel free to write a comment below if you have any questions!

Tuesday, July 28, 2009

cfa: 1. ethical & professional standards

My books arrived on Thursday, and I began studying over the weekend. The first 166 pages dealt with "Ethical and Professional Standards," which lays out the 7 Standards that all CFA charterholders and candidates must adhere to, including: Professionalism, Integrity of Capital Markets, Duties to Clients, Duties to Employer, Investment Analysis/ Recommendations/ Actions, Conflicts of Interest, and Duties to the CFA Institute. Half of the 4 Readings comprising this section also dealt with the "Global Investment Practice Standards (GIPS)," which has already been adopted by 25 countries as the standard for measuring and comparing investment performance. What surprised me most to learn, however, was that according to the CFA Topic Areas, the Ethics section had a higher percentage of test questions (15%) than every other section on the test besides "Financial Reporting & Analysis" (20%) and "Asset Valuation" (30%)!



The 8 sections that comprise GIPS include: Fundamentals of Compliance, Input Data, Calculation Methodology, Composite Construction, Disclosures, Presentation & Reporting, Real Estate, and Private Equity. A typical test question might ask you to recognize the various sections of GIPS, such as:

"With respect to the Global Investment Performance Standards, which of the following is one of the eight major sections that reflect the elements involved in presenting performance information?"
A. Real Estate.
B. Derivatives.
C. Legal and Ethical Considerations.
The answer is "A" by definition of the 8 sections that comprise GIPS.

Most of the 36 questions that followed the Ethics section would describe a potential ethical violation, and ask whether or not it was a violation, and which standard was violated:

"One of the discretionary accounts managed by Farnsworth is the Jones Corporation employee profit-sharing plan. Jones, the company president, recently asked Farnsworth to vote the shares in the profit-sharing plan in favor of the company-nominated slate of directors and against the directors sponsored by a dissident stockholder group. Farnsworth does not want to lose this account because he directs all the account's trades to a brokerage firm that provides Farnsworth with useful information about tax-free investments. Although this information is not of value in managing the Jones Corporation account, it does help in managing several other accounts. The brokerage firm providing this information also offers the lowest commissions for trades and best execution. Farnsworth investigates the director issue, concludes that management's slate is better for the long-run performance of the firm than the dissident group's slate, and votes accordingly. Farnsworth:
A. violated the Standards in voting the shares in the manner requested by Jones but not in directing trades to the brokerage firm.
B. did not violate the Standards in voting the shares in the manner requested by Jones or in directing trades to the brokerage firm.
C. violated the Standards in directing trades to the brokerage firm but not in voting the shares as requested by Jones.
D. violated the Standards in voting the shares in the manner requested by Jones and in directing trades to the brokerage firm.

The answer is "B". This may seem like a trick question at first. It is easy to lose concentration through the sheer size of the question, and the information contained. At face value it seems that Farnsworth lacks objectivity, and is not serving the best interests of his clients. More specifically, the two main issues of concern are: 1) does Farnsworth violate the standard of "Duties to Client: III(A) - Loyalty, Prudence, and Care)" by voting for the company-nominated slate of directors at the request of Jones, the company president? 2) does Farnsworth violate the same standard by directing trades to a brokerage firm to receive research reports that do not benefit the Jones Corporation? It would be easy to conclude that both of these issues would, in fact, be a violation. However, the reason why they are NOT violations is because Farnsworth came to his own independent decision after researching the issue (it just so happened that it is the same group that Jones recommended), and second, the clients benefit from the "lowest commissions for trades and best execution," so the issue of the research reports are irrelevant in this context. You can imagine a completely different answer had Farnsworth not researched the slate of directors, or if the brokerage firm had not provided the best prices and execution. The questions can be very subtle.

That wraps of Ethics, and now it's time to turn to "Quantatative Methods"! I hope to finish this section, which is 356 pages, by next week, at which point I'll post up my findings.

Thursday, July 23, 2009

waiting for CFA books

I registered for the CFA Level 1 exam on Tuesday, and I’m just now waiting for the study books to arrive. UPS tracking says that all 20lbs worth of books are making their way up from South Carolina, and should hopefully be arriving on my doorstep in New York shortly. In the meantime, I thought I would try to wrap my mind around exactly what to expect regarding the CFA curriculum, as well as the history behind the designation and why I thought it worthwhile to devote the rest of my summer to pursuing it.

The current CFA Institute traces its lineage back to the founding of the Financial Analysts Federation (FAF) in 1947. Before then, a few local societies existed for investment professionals, most notably the New York Society of Security Analysts (NYSSA), which predates the FAF by 10 years. NYSSA was founded by a group of professionals that included Benjamin Graham, the “father of securities analysis” (fundamental analysis), and acknowledged mentor of billionaire Warren Buffet.

The first actual CFA charters were not awarded until 1963, which ironically followed on the heels of great advancements in economic research out of the University of Chicago regarding financial markets, particularly with the development of the “efficient market theory (EMT).” Threatening to negate the utility of fundamental (and technical) analysis, EMT held that it was nearly impossible to beat market index returns through careful analysis of individual stocks, because all knowable information regarding the stock was instantaneously priced into them causing stocks to follow a “random walk” trading pattern. However, the success of value investors (Berkshire Hathaway) and technical investors (Renaissance Technologies hedgefund) largely refute the rigid orthodoxy of the “semi-strong” and “strong” forms of EMT.

Now that I have reassured myself that I didn’t just squander $1,100 on a designation that would be of no practical value to me, I turn to the actual content of the course. First, what does it take to become a CFA:

“In order to become a "CFA Charterholder" candidates must pass all three six-hour exams, possess a bachelor's degree (or equivalent, as assessed by the CFA institute) and have 48 months of work experience in an investment decision-making position. CFA charterholders are also obligated to adhere to a strict Code of Ethics and Standards governing their professional conduct”

Second, what are the most recent pass-rates for each level of the exam:
June 2008:    Level I: 35%     Level II: 46%     Level III: 53%

When we follow the success rate of candidates who pass through each of the 3-successive levels, then we can see that less than 9% of those who started the CFA process ultimately earn the designation. Okay now that we have established that the CFA is extremely hard, what exactly do we hope to learn, and how can this help prepare me for my Oxford MBA core-courses?

When deciding on what material will be included on the CFA exam, the CFA Institute solicits the advice of industry professionals on what the most relevant financial topics that a professional should know. The resulting “Candidate Body of Knowledge (CBOK)” is then parceled into 10 different “Topic Areas,” which are further divided into 18 “Study Sessions.” The topics are:

1. Ethics & Professional Standards 
2. Quantitative Methods 
3. Economics 
4. Financial Reporting & Analysis 
5. Corporate Finance 
6. Portfolio Management 
7. Equity Investments 
8. Fixed Income 
9. Derivatives 
10. Alternative Investments.

At first blush this might not seem too intimidating until you drill-down into "Quantitative Methods,” and realize that without the aid of a formula sheet, you will need to memorize: time value of money, probability, probability distributions and descriptive statistics, sampling and estimation, hypothesis testing, correlation analysis and regression, time series analysis, simulation analysis, and technical analysis. Whew-when I finish this my Finance I course should be a breeze!

Monday, July 20, 2009

next stop...cfa

Now that my fiancée and I have decided to book our flight to England on September 23rd (orientation begins Sept 30th and classes begin Oct 5th), I am left with roughly 2-months to finish sorting out my pre-MBA plans. You don’t have to be Gary Kasparov to know that the people who are successful in life plan several moves ahead. Of course even Kasparov can lose to IBM’s Deep Blue, so it’s always important to maintain some perspective and humility. Nevertheless it won’t stop be from trying to tip the odds for success in my favor!

First, you need balance. In a previous post I mention having joined a gym, and putting some much needed work into my tennis serve, to better prepare myself physically for the endurance challenge that is the Oxford MBA. Of course I’m also motivated by the fear I’ll be the largest person in the boat rowing for Exeter College in Oxford! Incidentally, I’ve heard from another classmate who swears that yoga is such great exercise that afterwards “you would have felt that you sweated off the equivalent of a small baby!” Regardless of which way you decide to shape-up, it's imperative to find some release for all the stress.

Second, to prepare for the coursework, I’m taking several steps, including brushing up on my personal finance by inching closer to completing my CFP® certification. With over 350,000 people claiming to be financial planners in America, only 10% have actually gone through the rigorous qualification process that I am currently going through. As a brief aside, most financial professionals in America widely agree that the following designations mark the highest of achievement in their respective fields: the CFA for financial analysts, the CFP® for personal finance, the CPA for public accounting, and the MBA for general management.

Now to become a “Certified Financial Planner” you must satisfy five principle qualifications, which are: 1) a minimum 3-years of qualifying financial planning work experience, 2) a bachelor’s degree, 3) completion of additional education requirements [typically 6 courses covering the financial planning process, insurance, investments, retirement, income tax, and estate planning], 4) an ethical background check, and 5) pass the 10-hour national Board exam. Currently, I’m waiting for my test results from the Certified Financial Planning Board. Roughly 50% of test-takers pass. I won’t know until I leave for England, however, but I’m optimistic. Nothing left to do but wait.

I believe holding both an Oxford MBA and the CFP® will help me during recruiting season. It would nicely qualify me for a job as a “private banker” on Wall Street. This would be very similar to what I do now as a financial advisor, except I would be swimming “upstream” by dealing with a wealthier clientele who face more sophisticated financial issues like how to finance their G5 private jet! Luckily, despite the recent financial market turmoil, private bankers are still very much in demand by both an aging population in the developed world, and by the increasing wealth of those in the developing world. I'm also excited to apply this background to opportunities in investment banking, private equity/venture capital, or management consulting.

Why relax!? I’m never one to slow-down, or rest on my laurels. So, now that I have the summer off and things are finally winding down, I’m looking for other ways to busy myself, and make my stay in Oxford a success! All the logistics are accounted for: my financing is in place, my accommodations confirmed, my college selected, my Visa applied for, and my post-MBA job search begun. After careful consideration, I have now decided that the best way for me to prepare for the MBA in these last 2-months is to register and study for the CFA Level 1 exam in December! Frank Sinatra has got nothing on me when he wrote "that he bit off more than he could chew" in the song "My Way."

Long considered the “gold standard” on Wall Street (besides the MBA), the “Chartered Financial Analyst” designation has come to symbolize the ultimate cerebral achievement for financial “quant jocks” around the world. In fact, studies show that individuals who hold both an MBA and CFA with 10-years experience earn an average of $250,000 per year! So, while CAPM and the Treynor ratio are still “Sharpe” in my mind from the CFP® exam, now is the perfect time to polish my HP12C financial calculator, and ready myself for the mental gymnastics needed to take-on the CFA and catapult myself ahead of the curve for such upcoming core MBA courses as Finance 1, Decision Science, and Financial Reporting. Keep checking in if you want to re-connect with your own inner quant-jock, as I will continue to post info on the CFA, as well as the Oxford MBA.