- Relationship between dependent variable and independent variables is linear.
- There is no linear relationship between independent variables and they are also not random. If there is linear relationship between independent variables, it is called
**Multicollinearity**leading to high R^2 and significant F Stat. This results in inflated Std Err and low T Stat ( opposite of heteroskedasticity effect). - Expected value of Error term is 0 and Error term is normally distributed.
- Variance of Error term is the same for all observations. If this assumption is not true, it is called
**Heteroskedasticity.**This can be tested by Breuch Pagan test. If there is Heteroskedasticity . , then Fstat is unreliable and SError is understated and T stat is overstated. - Error term is uncorrelated across observations. If it is correlated, then it is called
**Serial Correlation.**This is tested using Durban Watson (DW) test. Here F stat and T stat is too high. DW = 2(1-r)

# Monthly Archives: September 2015

# Adhoc topic. Download stock price from Yahoo Finance.

# Correlation

How does the nature of the dependent variable vary based on the independent variable ? – This is explained by taking a sample of the population and computing Covariance.

This just shows if the two variables are positively related (or) negatively related (or) not related at all.

Assuming x is independent and y as dependent, have a number of observations and plot scatter diagrams for visual view.

Covariance = Sum of (( x – x bar) ( y – y bar)) / (n-1)

For Covariance to be applicable cov(x,y) = cov(y,x) and Cov(x,x) = variance (x).

The sample correlation coefficient is derived from sample Covariance so it can be used as a unitless measure to compare apples to apples.

Correlation Coefficient = Cov(x,y) / std x . std y

std x = **sqrt**(sum(x – x bar)/ n-1 )

# LIFO Reserve Basics

A good video that explains LIFO Reserve Basics

Points to Note

LIFO Inv + LIFO Reserve = FIFO Inv

For the next year

LIFO Reserve = Prev year’s LIFO Reserve + ( LIFO Cogs – FIFO Cogs)

To make it easy to digest, we can rearrange the above and state as

LIFO Cost of good sold = FIFO Cost of goods sold + ( Change in LIFO reserves)

Eg

Year 1 — LIFO Inv = 200, LIFO Res = 100, then FIFO Inv = 300

Year 2 – If LIFO Cogs = 400 and FIFO Cogs = 50, then this difference is 350. This is to be added to the opening balance of LIFO Reserve which is 100 resulting in the new LIFO Reserve for year 2 as 100 + 350 = 450.

When LIFO method is used in US GAAP, the LIFO Reserve needs to be reported as well to signify the reserve or additional inventory had the FIFO method was followed ( in an environment of increasing inventory cost).

When LIFO liquidation happens, LIFO is selling more goods that was bought at lower cost , thereby increasing gross profit. Gross profit due to LIFO liquidation =( # of units liquidated) * (Replacement cost of the units liquidated – historical purchase cost of those units).

Good reference link for Inventory related topic.

# Understanding of Spot Rate, Forward Rate and Forward Price Calculation

This is a good video that explains in simple terms the Spot Rate, Forward rate and forward price from CFA Level 2 perspective.

Eg: yr1 spot rate = 3%, yr2 = 4% yr3 = 6%

Assuming FV = $1000 and a cash flow is $50 per year, use scientific calculator to compute PV of these cash flows.

Using the PV, the YTM can be obtained.

To obtain forward rates using these spot rates, eg. 1 year forward rate 1 year from now, we can use yr2 spot rate and yr1 spot rate to calculate the result. In other words, if I need to earn 4% overall in 2 years and I am investing at 3% for first year, then what should be my rate 1 year from now for the next 1 year, so I can take the money from year 1 investment and reinvest it at this new rate. Based on no arbitrate theory (1+ yr1 spotrate) * (1+ yr 1 forward rate for 1 yr) = (1 + yr2 spot rate)^2

Trying one or more examples will make this really simple and intuitive.

# Good study links..

# Put Call Parity

Formula 15.11

c + PV(x) = p + s

Where:

c = the current price or market value of the European call

x = option strike price

PV(x) = the present value of the strike price ‘xeuropean’ discounted from the expiration date at a suitable risk-free rate

p = the current price or market value of the European put

s = the current market value of the underlying stock.

The put-call parity formula shows the relationship between the price of a put and the price of a call on the same underlying security with the same expiration date, which prevents arbitrage opportunities. A __protective put__ (holding the stock and buying a put) will deliver the exact payoff as a fiduciary call (buying one call and investing the present value (PV) of the exercise price).

For the exam, you should know that a protective put = fiduciary call (asset + put = call + Bond)

Source : Investopedia.

Eg: Rearraging the above formula, if I buy a protective put and also sell call option, that results in equation

x = asset + put – call. where x can be strike price of bond or cash, which will be a constant, thereby proving the put call parity.