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Valuationofshares-Iapm 2942
Valuationofshares-Iapm 2942
Valuationofshares-Iapm 2942
Contents
S.No.
Topic
Slide No.
Financial Markets
33
89
141
156
213
Valuation of Derivatives
245
Investment Management
278
2
Chapter 1
Introduction
Investments are made into :
Financial assets, like, stocks, bonds, or similar instruments
Real assets, like, houses, lands, or commodities
asset classes.
To manage the expected returns requirement for the corresponding risk
tolerance.
To maximize the return subject to the risk-tolerance level or to achieve a prespecified level of return with minimum risk.
Types of Investors
Diversity among investors depending on their investment styles,
mandates, horizons, and assets under management.
Investors
Mutual
Funds
Individual
Institutions
Pension
Funds
Endowment
Funds
Insurance
Companies
Banks
7
Investors : Individuals
Single largest group in most markets, while portfolio size is quite small.
Differ across risk appetite and return requirements in their portfolios:
Averse to risk - Inclined towards safe investments, like Government securities
Investors : Institutions
Largest active group in the financial markets.
Are essentially representative organizations, i.e., invest capital on behalf
of others, like individuals or other institutions.
Assets under management are large and managed professionally by
fund managers.
11
the employees.
Objective: To provide benefits to the employees post their retirement.
The premium for such policies may be higher than term policies.
14
15
17
Hedgers
Invest to provide a
cover for risks on a
portfolio they
already hold
Speculators
Arbitrageurs
Day Traders
Take simultaneous
positions (say in two
equivalent assets or
same asset in two
different markets
etc.) to earn riskless
profits arising out of
the price differential
if they exist
Trade in order to
profit from intra-day
price changes
Invest directly in
securities in cash
markets, and in
derivatives,
instruments that
derive their value
from the underlying
securities
18
Constraints
Every investor has some constraint (e.g. risk profile, the time horizon, the
choice of securities, optimal use of tax rules, etc.) within which he/she
wants the portfolio to lie.
Constraints
Liquidity
Investment
Horizons
Taxation
19
Constraints : Liquidity
Refers to the marketability of the asset (i.e., the ability and ease of an
asset to be converted into cash and vice versa)
Measured across 2 parameters :
1. market breadth (or, impact cost) - measures the cost of transacting a given
volume of the security
2. market depth - measures the units that can be traded for a given price
impact
Constraints : Liquidity
High demand and supply of the security results in low impact costs of
trading and reduce liquidity risk.
21
22
month) then the impact cost (liquidity) becomes significant as it could form a
meaningful component of the expected return.
24
Constraints : Taxation
Tax-free investments or investments subject to lower tax rate may trade
at a premium as compared to investments with taxable returns.
Asset
A
B
Type
10% taxable bonds (30% tax)
8% tax-free bonds
Expected Return
10%
8%
Net Return
10%*(1-0.3) = 7%
8%
(In the table, A carries higher coupon rate. But, net return for the
investors would be higher for asset B. Hence, asset B would trade at a
premium as compared to asset A.)
25
Constraints : Taxation
Taxation benefits (if available on specific investments) must be
considered before deciding investment portfolio.
26
Goals of Investors
Investment decisions depend upon investors plan as per needs.
Other factors affecting an investors choice for investment :
Level of requisite knowledge (investors may not be aware of certain financial
instruments and their pricing),
Investment size (e.g., small investors may not be able to invest in Certificate
of Deposits),
27
MCQs
Q1. An endowment fund is an institutional investor.
(a) FALSE
(b) TRUE
28
MCQs
Q3. Portfolio management is required to manage the expected _______
requirement for the corresponding ________.
(a) income, expenditure
(b) gain, losses
(c) profit, loss tolerance
(d) return, risk tolerance
29
MCQs
Q4. In investment decisions, _______ refers to the marketability of the
asset.
(a) value
(b) profitability
(c) price
(d) liquidity
30
MCQs
Q5. Banks and other financial institutions generally create a portfolio of
fixed income securities to fund known _______ .
(a) assets
(b) liabilities
31
32
Chapter 2
Financial Markets
33
34
Introduction
Financial
Markets
Money
Market
Primary
Market
Capital
Market
Secondary
Market
Third Market
(OTC Market)
Fourth
Market
35
Introduction
Money Market
securities
market instruments**.
market instruments.
** Derivative market instruments are mainly futures, forwards and options on the underlying
instruments, usually equities and bonds.
36
Primary Market
Deals with the raising of capital from investors via issuance of new
securities.
New stocks/bonds are sold by the issuer to the public.
first time.
Follow-up Offerings : issuer wants to issue more securities of a
Primary Market
E.g. Reliance Power Ltd.s offer in 2008 was an IPO because it was for the
first time that Reliance Power Ltd. offered securities to the public.
BEMLs public offer in 2007 was a Follow-up Offering as BEML shares were
already issued to the public before 2007 and wereavailable in the secondary
market.
the offer.
No prevailing market for security in case of an IPO, hence difficult.
38
Primary Market
Companies must estimate correct price of offer :
Risk of failure of the issue in case of non-subscription if the offer is
overpriced.
If the issue is underpriced, the company stands to lose notionally since the
securities will be sold at a price lower than its intrinsic value, resulting in
lower realizations.
39
40
Exchange.
Securities traded may or may not be traded on a recognized stock
exchange.
Trading generally open to all registered broker-dealers (regulatory
Fourth Market
Direct transactions between institutional investors, undertaken
primarily with transaction costs in mind.
42
**Conditions may be related to the price of the security (limit order or market order or stop
loss orders) or related to time (a day order or immediate or cancel order). Electronic
exchanges used now a days.
43
Types of Orders
Limit Price/Order
Market Price/Order
44
45
47
pre-determined price
Step 4 : Order enters into system as a market/limit order and is executed
48
price in the normal market reaches or falls below the trigger price of
the order.
Step 6 : Buy order in the stop loss book triggered when the last traded
price in the normal market reaches or exceeds the trigger price of the
order.
(Trigger price should be less than the limit price in case of a purchase order and vice
versa.)
49
All orders are Day Orders at the National Stock Exchange (NSE)
50
system.
Partial match possible for the order and the unmatched portion of
51
Matching of Orders
Order received
Time Stamped
Processed for
potential match
Match found
Order is stored in
pending orders book
till a match is found
52
Matching of Orders
Order can also be executed against multiple pending orders, resulting in
more than one trade per order.
The matching of orders at NSE is done on a price-time priority i.e., in
the following sequence:
Best Price
Within Price, by time priority
53
Matching of Orders
Market orders : executed instantly
Limit orders : remain in the trading system until their market prices are
reached
Limit Order Book (LOB) of the exchange : orders across stocks at any point in
time in the exchange
Top five bids/asks (limit orders all) for any security are usually visible to
market participants and constitute the Market By Price (MBP) of the security.
54
364 days.
Issued weekly (91-days maturity) and fortnightly (182-days and 364-days
maturity).
58
by large corporate houses in order to diversify their sources of shortterm borrowings and to provide additional investment avenues to
investors
Issuing companies required to obtain investment-grade credit ratings
from approved rating agencies (papers also backed by a bank line of credit)
Also issued at a discount to their face value
59
60
61
In India,
Scheduled banks can issue CDs with maturity ranging from 7 days - 1 year
Financial institutions can issue CDs with maturity ranging from 1 year - 3 years
64
Bond Market
Instruments:
Corporate Bonds
International Bonds
Treasury Bonds
debts are either repaid from future revenues generated from such
projects or by the Government from its own funds.
67
68
69
71
73
Option gives the right to the issuer to repurchase (cancel) the bond by
paying the stipulated call price
Call price may be more than face value of bond
74
75
Coupon rate : reset every six months (time between two interest payment
dates)
76
Common Stock
Shareholders of a company have limited liability (liability of
shareholders is limited to the unpaid amount on the shares)
Maximum loss of shareholder in a company is limited to her original
investment
Shareholders have the last claim on the assets of the company at the
Common Stock
Shares valued much higher than the face value
Initial investment in the company by shareholders represents their
paid-in capital in the company.
Company generates earnings from its operating, investing and other
activities, portion of which is distributed back to the shareholders as
Equity
Preference
79
81
MCQs
Q1. The issue price of T-bills is generally decided at an ______ .
(a) OTC market
82
MCQs
Q2. ______ orders are activated only when the market price of the
relevant security reaches a threshold price.
(a) Limit
(b) Market-loss
(c) Stop-loss
(d) IOC
83
MCQs
Q3. In India, Commercial Papers (CPs) can be issued by _____.
(a) Mutual Fund Agents
84
MCQs
Q4. New stocks/bonds are sold by the issuer to the public in the
________ .
85
MCQs
Q5. A ________, is a time deposit with a bank with a specified interest
rate.
86
MCQs
Q6. In the case of callable bonds, the callable price (redemption price)
may be different from the face value.
(a) FALSE
(b) TRUE
87
88
Chapter 3
89
90
Introduction
Fixed-income securities have some pre-specified values
Pre-specified values can be:
1.Maturity amount
2.The time of the maturity due
91
Interest
Extra money paid by the borrower to the lender
The price for the use of the borrowed amount over the given period
of time
Interest cost covers the opportunity cost of the money
The rate of interest may be fixed or floating
92
Interest Calculations
Two Types of Interest Calculations:
1. Simple Interest - Calculated on the principal amount alone.
2. Compound Interest - We assume that all interest payments are reinvested at the end of each period
Interest
Simple
Compound
93
Simple Interest
Simple- it ignores the effects of compounding
Simple Interest (S.I)= PRT
where:
P = Principal
R = Rate of Interest for one period (usually 1 year)
T= Number of periods (years)
94
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pays 8% simple interest?
Ans : Given:
P = 10000, R = 8% and T = 3 years
I = P R T = 10000 8% 3 = 2400
Amount = Principal + Interest = 10000 + 2400
Therefore the amount an investor will get = 12400
95
Example
Que : Braun invested a certain sum of money at 8% p.a. simple interest
for T' years. At the end of T' years, Braun got back 4 times his original
investment. What is the value of T?
Example
Here P = $100 , I = $300 and R = 8%
We know , I = P R T
=> 300 = 100 8% T
T = 300/100 8% = 37.5 years
97
Compound Interest
Apart from the normal P, R and T, there is a fourth factor m.
98
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pay 8% interest compounded half yearly?
Ans : Given P = 1000, R = 8% , T = 3 and m = 2
The total interest income is:
Interest=[P(1+R/m)Tm]-P (where is raise to power)
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pay 8% interest compounded Monthly?
Continuous Compounding
Sum of money is compounded infinitely throughout the year
Example
Que. Consider the same investment (Rs. 10000 for 3 years). What is the
amount received on maturity if the interest rate is 8% compounded
continuously?
Ans : Here P= 10000 , e=2.718 , r=8% and T=3
The final value of the investment is P*ert
inflation
It is the rates quoted in loan and deposit agreements
Nominal cash flows measure the cash flow in terms of todays prices
104
of inflation
Real cash flows measure the cash flow in terms of its base years
purchasing power
Real Cash flow= Nominal Cash flow/(1+inflation rate)
105
Bond Pricing
The cash inflow for an investor includes:
1.The coupon payments
2.Payment on maturity of the bond
Thus the price of the bond should represent the sum total of the
discounted value of each of these cash flows.
The discount rate is generally higher than the risk free rate
106
Bond Pricing
Bond Price = PV ( Coupons and Face Value)
T= time of maturity
y= discount rate
Example
108
Example
What happens if the discount rate is lower than the coupon rate?
109
dirty price
The price of the bond excluding accrued interest is called the clean price
Bond Yields
The amount of return an investor will realize on a bond
Bond yields are measured using the following measures:
1) Coupon yield
2) Current yield
3) Yield to Maturity
4) Yield to Call
111
Coupon Yields
It is simply the coupon payment C as a percentage of the face value F
It is also called nominal yield
112
Current Yield
It is simply the coupon payment C as a percentage of the current
bond price P
113
Example
Que. Monique Moneybags purchased one XYZ convertible mortgage
bond at 105. Two years later, the bond is trading at 98.If the coupon
rate of the bond 6%, what is the current yield of the bond?
Ans : The current market price is $980 ( 98% of $1000 per value)
The annual interest is $60 (6% coupon rate $1000 per value)
Current yield = Annual Interest/current Market bond price
Current yield = $60/$980 = 6.1%
114
Drawbacks
The main drawbacks of Coupon yield and Current Yield are:
1) They consider only the coupon (interest) payments
115
Refers to the IRR earned from holding the bond till maturity
It is a rate that equalizes the present value of the cash flows to the
116
117
The yield to maturity is the discount rate solved using the following
formula:
118
Yield to call
It is calculated for callable bond
Before the date of actual maturity , issuer has the right to call/redeem
the bond
119
Interest Rates
There are three types of common interests:
1. Short Rate - the expected rate at which an entity
120
Interest Rates
Relationship between spot rate and short rate
121
Example
Que. If the short rate for 1-year investment at year 1 is 7% and year 2 is
8%,what is the present value of a 2-year zero coupon bond with face
value RS 1000 ?
Ans: P=1000/1.071.08 = 865.35
For a 2-year zero coupon bond trading at 865.35,the YTM can be
calculated by solving the equation: 865.35 = 1000/(1+y2)^2
=> y = 7.4988%,which is nothing but the 2-year spot rate.
122
Application- Yield curves are used as a key tool by central banks in the
determination of the monetary policy
123
124
The forward rate equals the market expectation of the future short
interest rate i = E(ri ) where i is a future period
The expected interest rate can be used to construct a yield curve
The formula is:
125
preferred
Investors will be induced to hold a long-term investment, only by
126
the time to maturity and time to various coupon payments to find the
effective maturity for a bond.
127
128
The price changes for fixed income securities are dependent mainly on
the interest rate changes and the average maturity (duration).
129
the reinvestment rates will offset the opposite changes in the market
values of the bonds in the portfolios.
The net realized yield at the target date will be equal to the yield to
maturity of the original portfolio.
130
MCQs
Q1) Security of ABC Ltd. trades in the spot market at Rs 595. Money can
be invested at 10% per annum. The fair value of a one-month futures
(b) 620.05
(c) 600.05
(d) 610.05
131
MCQs
Q2) In the case of callable bonds, the callable price (redemption price)
may be different from the face value.
(a) FALSE
(b) TRUE
132
MCQs
Q3) Term structure of interest rates is also called as the ______.
(a) term curve
133
MCQs
Q4) ______ are a fixed income security
(a) Equities
(b) Forex
(c) Derivatives
(d) Bonds
134
MCQs
Q5) In a Bond the ____ is paid at the maturity date
135
MCQs
Q6) Security of ABC Ltd. trades in the spot market at Rs.525. Money
can be invested at 10% per annum. The fair value of a one-month
futures contract on ABC Ltd. is (using countinously compounded
method):
(a) 559.46
(b) 549.46
(c) 539.46
(d) 529.46
136
MCQs
Q7) One needs to average out the time to maturity and time to various
coupon payments to find the effective maturity for a bond. The
measure is called as _____ of a bond.
(a) duration
(b) IRR
(c) YTM
(d) yield
137
MCQs
Q8) In case of compound interest rate, we need to know the _______
for which compounding is done.
(a) period
(b) frequency
(c) time
(d) duration
138
MCQs
Q9) What is the amount an investor will get on a 1-year fixed deposit of
Rs. 10000 that pays 8% interest compounded quarterly?
(a) 12824.32
(b) 13824.32
(c) 10824.32
(d) 11824.32
139
c
b
b
d
a
d
a
b
c
140
Chapter 4
Capital Market Efficiency
141
142
Introduction
What is Market Efficiency?
Efficient Market Hypothesis (EMH) forms the basis of Modern
Financial Theory.
Markets are said to be efficient when the prices of securities
assimilate and reflect information about them.
143
Market Efficiency
Impact of Market Efficiency
If the prices reflect all the information instantly, then the prices can be used
for various economic decisions.
For instance, a firm can assess the potential impact of increased dividend by
measuring the price impact created by it.
144
relevant information.
Characterization of level of efficiency of the market :
a) Weak-form Market Efficiency
b) Semi-Strong Market Efficiency
c) Strong Market Efficiency
145
information gets reflected in the prices and no one can earn in excess.
Tested by checking if insiders of a firm are earning in excess compared
to the market, absence of any excess would imply the market to be
strongly efficient.
Testing the strong-form efficiency is difficult, hence the claim of the
efficiency in the market remains the best option.
148
The lack of reliability about the level of efficiency of the market prices
makes it less reliable as a guideline for decision-making.
149
their investment ability, they would not pay close attention to new
price relevant information that arises in the market. This leads to,
1. Inadequate price response to the information event.
2. Continuation of the trend due to the under reaction.
Conclusion
The alternative prescriptions about the behaviour of markets based
MCQs
Q1. If the market is _______, the period after a favorable (unfavorable)
event would not generate returns beyond (less than) what is
suggested by an equilibrium model such as CAPM.
(a) weak-form efficient
(b) strong form efficient
153
MCQs
Q2. __________ would mean that no investor would be able to
154
155
Chapter 5
156
157
Introduction
Decision to invest is linked to :
Evaluation of companies
Their Earnings and Potential for future growth
What is Valuation ?
Examination of future returns or the cash flows expected from an asset.
158
Financial Analysis
Income
Statement (Profit
& Loss)
Balance Sheet
Cash Flow
Statement
159
160
Other assets Carry value but not directly marketable like Patents, trademarks
161
162
163
Financial Ratios
Meaningful links between different entries of financial statements.
164
Return on Total Capital = Net Income + Gross Interest Expense / Average total capital
165
Ratios :
Current ratio = Current Assets / Current Liabilities
Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
166
167
168
169
Common Shareholders
Owners of the firm.
Appoint the management and Board of director for the management of
firm.
The cash flows (return) are in the form of current and future dividends
distributed from the profits of the firm
170
171
Intrinsic
Discount
ed Cash
Flows
Constant
Dividend
Growth
Present
Value of
Growth
Opportu
nities
Relative
Discount
ed Free
Cash
Flow
Earning
Per
Share
Dividend
Per
Share
Price
Earning
ratio
Price
Book
Ratio
Return
on
Equity
Du Pont
Model
Dividend
Yield
Return
to
Investor
172
We can write the share price at the end of the year 1 as a function of
the 2nd year dividend and price of share at the end of the year 2.
173
Share Price : Po
Div1
rg
Example
Que: RNL has paid a dividend of Rs. 10 per share last year (D0) and it is
expected to grow at 5% every year. If an investors expected rate of return
from RNL share is 7%, calculate the market price of the share as per the
dividend discount model.
Answer: The following are given:
Dividend per share last year = Div0 = 10
Growth factor= g = 5% = 0.05
Expected rate of return= r = 7% = 0.07.
176
Example
Dividend per share this year = Div1 = Div0 * (1+ g) =10 * 1.05 = 10.50
Market price of share = P0 = Div1/(r-g) = 10.50/(0.07-0.05) = 525
Market price of RNL share as per the dividend discount model with
constant growth rate is Rs. 525.
177
179
180
181
Free Cash flow: Cash that a company is able to generate after laying out
the money required to maintain or expand its asset base.
184
185
186
Example
Que. The following is the figure for Asha International during the year
2008-09:
Net Income: Rs. 1,000,000
Number of equity shares (2008): 150,000
Number of equity shares (2009): 250,000
Dividend paid: Rs. 400,000
Calculate the earnings per share (EPS), dividend per share (DPS), dividend
payout ratio and retention ratio for Asha International.
187
Example
Ans.
188
189
Example
Que : Stock XYZ, whose earning per share is Rs 50 is trading in the
market at Rs 2000. What is the price to earnings ratio for XYZ?
Ans : Price earnings Ratio
= Market price per share / annual earning per share
= 2000/50 = 40
190
191
192
Example
Que : XYZ Company net income after tax for the financial year ending
31st March, 2009 was Rs. 10 million and the equity share capital as on
31st March, 2008 and 31st March 2009 was Rs. 80 million and Rs. 120
million respectively. Calculate the return on equity of XYZ company for
the year 2008-09.
193
using its assets better (higher asset turn) or a combination of all three.
194
195
196
Example
Que : ABC Company paid a dividend of Rs. 5 per share in 2009 and the
market price of ABC share at the end of 2009 was Rs. 25. Calculate the
197
Example
Expected Return(r) = Dividends+ (market priceof the share)
OpeningMarket Price
Que : The share price of PQR Company on 1st April 2008 and 31st
Example
Answer:
Expected Return(r) = Dividends+ (market priceof the share)
OpeningMarket Price
= 6 + (84 80)
80
= 10/80 = 12.5 %
199
200
Example
Que. If a firm has $100 in inventories, a current ratio equal to 1.2, and a
quick ratio equal to 1.1, what is the firm's Net Working Capital?
201
MCQs
Q1. A company's __________ provide the most accurate information to
its management and shareholders about its operations.
(a) advertisements
(b) financial statements
(c) products
MCQs
Q2. Gross Profit Margin = Gross Profit / Net Sales
(a) FALSE
(b) TRUE
MCQs
Q4. Net acquisitions / disposals appears in the Cash Flow Statement of
Companies.
(a) TRUE
(b) FALSE
204
MCQs
Q5. _______ measures the percentage of net income not paid to the
shareholders in the form of dividends.
MCQs
Q6. Which of the following accounting statements form the backbone
of financial analysis of a company?
MCQs
Q7. The balance sheet of a company is a snapshot of the ______ of the
MCQs
Q8. A ________ provides an account of the total revenue generated by
MCQs
Q9. Dividend Per Share = Total Dividend / Number of Shares in issue
(a) TRUE
(b) FALSE
209
MCQs
Q10. To measure a firm's solvency as completely as possible, we need to
consider
a. The firm's relative proportion of debt and equity in its capital structure
b. The firm's capital structure and the liquidity of its current assets
c. The firm's ability to use Net Working Capital to pay off its current liabilities
d. The firms leverage and its ability to make interest payments on its long-term
debt
e. The firm leverage and its ability to turn its assets over into sales
210
MCQs
Q11. Which of the following is considered a profitability measure?
c. Price-earnings ratio
d. Cash coverage ratio
e. Return on Assets
211
b
b
a
a
b
d
a
d
a
d
e
212
Chapter 6
Modern Portfolio Theory
213
214
Introduction
Two building blocks to analyze this behavior :
Portfolio theory
Equilibrium Mode
215
Portfolio Theory
Theory about the risk - return characteristics of assets in a portfolio.
216
Example
Que. What is the expected return for the following portfolio?
Stock
Expected returns
Investment
AAA
31.2%
$190,000
BBB
24.0%
$350,000
CCC
18.6%
$200,000
DDD
11.9%
$500,000
218
Example
Ans.
Stock
Expected returns
Investment
AAA
31.2%
$190,000/1,240,000 = 0.1532
BBB
24.0%
$350,000/1,240,000 = 0.2823
CCC
18.6%
$200,000/1,240,000 = 0.1613
DDD
11.9%
$500,000/1,240,000 = 0.4032
TOTAL $1,240,000
Example
Que. You are considering buying a stock with a beta of 2.05. If the risk
free rate of return is 6.9 percent, and the market risk premium is 10.8
percent, what should the expected rate of return be for this stock?
Ans. ki = kRF +(kM - kRF)bi
ki = 6.9% + (10.8%)(2.05)
ki = 29.04%
220
Inference
Risk of the portfolio would be lower than individual stocks considered
separately.
Portfolio variance is the weighted sum of variance as well as the
covariance.
Minimum portfolio standard deviation would always correspond to that
of the stock with the least standard deviation.
Value of W should be chosen in a way so that the portfolio risk can be
brought down below that of the least risky stock in the portfolio.
222
223
Inferences
1. For larger N, portfolio variance would be dominated by covariance
rather than variances.
225
Market Behaviour
Beta
226
Mean-Variance Investors
Investors are mean-variance optimizers.
Portfolios with higher return for the same level of risk or minimum risk
227
Portfolios chosen
Efficient Portfolios : Portfolios offering the maximum return for any
given level of risk.
228
Efficient Portfolio
229
Explanation
Market portfolio : Combination of all the risky assets.
Nature of portfolio M:
Same portfolio as M identified by 1) Investors having same portfolio
2) Investors having same information
230
Market Behavior
To examine the aggregate behavior of the market - mean-variance
space used.
All assets mapped on a return-standard deviation space.
Combinations- characterized theoretically as correlation of stocks are
between 0 to 1.
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Efficient frontier
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Explanation
All feasible combinations - space enclosed by the curve and straight line.
Curved line - correlations of stocks are less than 1.
Straight line - stocks with maximum correlation.
No portfolios would lie to the right of the straight-line.
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Explanation
Portfolio A would be preffered to B, as it has lower risk for the same
level of return offered by B.
CML Line
Capital Market Line.
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Risk Premium
Rate of risk required for unit variance of the market = RM-RF/ 2M.
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Estimation of beta
Beta measures the sensitivity of the security compared to the market.
If beta is k, then if market moves down/up by 1%, the security is
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Estimation of beta
Regression equation,
Ri = i + i RM + ei
Regression coefficient (i) represents the slope of the linear
relationship between the stock return and the market return, and
i denote the risk-free rate of return.
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Estimation of beta
Therefore, the beta of any stock can be conveniently estimated as a
regression between the return on stock and that of the market.
If the firm holds more risky assets the beta shall also be higher.
A firms beta is the weighted average of the beta of its assets.
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Example
Que. If the risk-free rate is 4.3%, the expected return on the market is
15.7%, and the expected return on Security J is 21.5%, what is the beta
For Security J?
Ans. ki = kRF +(kM - kRF)bi
APT Model
Investor portfolio is exposed to a number of systematic risk factors.
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MCQs
Q1. The CAPM is founded on the following two assumptions (1) in the
(a) TRUE
(b) FALSE
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Chapter 7
Valuation of Derivatives
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Introduction
Derivatives are a wide group of financial securities defined on the
the world and the turnover in the futures and options market
(covered later) exceeds that in the cash (underlying) market.
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The agreed rate is called forward rate and the difference between
spot rate and forward rate is called the forward margin.
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The option to buy is called Call Option and the option to sell at
agreed price (strike rate or exercise price) is called Put Option.
The seller collects a payment called premium from the other party for
having granted the option.
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sell, the buyers are protected from downside risks as well as enables
them to reap benefits from favorable movement in exchange rate.
The maximum loss that a buyer can suffer is the premium paid to
enter into the contract.
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Example
Security of ABB Ltd trades in the spot market at Rs. 850. Money can be
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Option Pricing
a) Payoffs from option contracts
Payoffs from an option contract (excluding initial premium amount)
refer to the value of the option contract for the parties (buyer and
seller) on the date the option is exercised.
In case of call options, the option buyer would exercise the option
only if the market price on the date of exercise is more than the
strike price of the option contract.
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Option Pricing
Otherwise, the option is worthless since it will expire without being
exercised.
Similarly, a put option buyer would exercise her right if the market
price is lower than the exercise price.
This would be clear in the diagrams in the next two slides.
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Payoff diagrams for call options buyer and seller (Assumed exercise
price = 100)
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Payoff diagrams for call option buyer and seller (exercise price
assumed=100).
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Value of call option (C); PV of exercise price (Kert ); value of put option
(P);Current share price (S0 )
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Black-Scholes Formula
The main question that is still unanswered is the price of a call option
for entering into the option contract, i.e. the option premium. The
premium amount is dependent on many variables.
a) Share Price (S0)
b) Exercise Price (K)
c) The time to expiration i.e. period for which the option is valid (T)
d) Prevailing risk-free interest rate (r)
e) The expected volatility of the underlying asset
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Black-Scholes Formula
The Black-Scholes formula for valuing call options (c) and value of put
options (p) is as under:
Example
Que. Find the prices for a call and a put, and the probabilities (both
Ans. The call price is 6.97167, while the put price is 14.2558. The riskneutral probability is 0.4363, and the physical probability is 0.46027.
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Example
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Example
On March 6, 2001, Cisco Systems was trading at $13.62. We will
attempt to value a July 2001 call option with a strike price of $15,
trading on the CBOT on the same day for $2.00. The following are the
annualized as follows:
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Example (cont.)
Weekly standard deviation = 1.556%
Annualized standard deviation =1.556%*52 = 81%
The option expiration date is Friday, July 20, 2001. There are 103 days
to expiration.
Example (cont.)
Strike Price on the option = $15.00
Option life = 103/365 = 0.2822
Standard Deviation in ln(stock prices) = 81%
Riskless rate = 4.63%
Inputting these numbers into the model, we get
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Example (cont.)
Using the normal distribution, we can estimate the N(d1) and N(d2)
N(d1) = 0.5085, N(d2) = 0.3412
The value of the call can now be estimated:
MCQs
Q1. Mr. A buys a Call Option at a strike price of Rs. 700 for a premium
of Rs. 5. Mr. A expects the price of the underlying shares to rise above
Rs. ______ on expiry date in order to make a profit.
(a) 740
(b) 700
(c) 720
(d) 760
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MCQs
Q2. The price of a derivative is dependent on the price of another
security, called the _____ .
(a) basis
(b) variable
(c) underlying
(d) options
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MCQs
Q3. Call Options can be classified as :
(a) European
(b) American
(c) All of the above
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MCQs
Q4. Mr. A buys a Put Option at a strike price of Rs. 100 for a premium of
Rs. 5. On expiry of the contract the underlying shares are trading at
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2) c
3) a
4) a
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Chapter 8
Investment Management
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Introduction
Two kinds of companies in asset management industry :
Engaged in investment advisory
Introduction
What is a Mutual Fund ?
also known as mutual funds, investment funds, managed funds or
simply funds
represents positions in each of the securities owned in the portfolio
clients track returns on the net asset value (NAV) of the fund, instead of
tracking return on their own portfolios
Investment Companies
Pool funds from various investors and invest the accumulated funds in
various financial instruments or other assets
Profits and losses from the investment (after repaying the management
expenses) distributed to investors in funds in proportion to the
investment amount
Run by an asset management company who simultaneously operate
various funds within the investment company
Each fund is managed by a fund manager who is responsible for
management of the portfolio
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Liquidity (easy entry and exit of investment : investors can with ease
buy units from mutual funds or redeem their units at the net asset
value either directly with the mutual fund or through an advisor / stock
broker.
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marketbeating returns
Investors view about the relative under pricing or over pricing of an
asset
Over pricing presents an opportunity to engage in short selling, under
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rate of return
E.g. estimated by an equilibrium asset pricing model like the CAPM
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Classification of funds
Open and Closed ended funds : Funds are also classified into the
following types based on their investments:
a)Equity Funds
b)Bond Funds
c)Money Market Funds
d)Index Funds
e)Fund of funds
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Closed-ended funds
Closed-ended funds sell units only at the
outset and do not redeem or sell units
of issue / redemption
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Income Funds
yield
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money from investors and have a fixed portfolio of assets, which are
not changed during the life of the fund. Once established the portfolio
agree to pool their funds and hire fund managers to manage their
portfolio.
Hedge funds are private agreements and generally have little or no
regulations governing them. This gives a lot of freedom to the fund
managers. Eg: Hedge funds can go short (borrow) funds and can invest in derivatives
instruments which mutual funds cannot do.
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Example
Que. A portfolio has an average monthly return of 1.5% and a standard
RP RF 1.5% 0.25%
Sharpe ratio
0.21
SD( RP )
1.2%
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Treynor Ratio
Treynors measure evaluates the excess return per unit of systematic
risks () and not total risks.
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Example
Que. From 1988-2007, the S&P 500 earned an average 13.9% per year
Ans. The Sharpe Ratio shows the amount of risk premium earned relative
to total risk, where total risk is measured by standard deviation:
Example
The market as a whole provided 0.66% additional risk premium for
= (13.9% - 4%)/1.0
= 9.90
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Example
Que. Assume the following information:
Your Portfolio
The Market
Expected return
15%
Expected return
14%
Standard deviation
20%
Standard deviation
12%
Beta
1.3
Beta
1.0
If the risk-free rate is 5%, calculate and compare the Sharpe Ratio and the
Treynor Index for both Your Portfolio and The Market. Did your portfolio
beat the market on a risk-adjusted basis?
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Example
Ans.
Your Portfolio
RP RF 15% 5%
Sharpe
0.50
SD( RP )
20%
Treynor
RP RF
The Market
RP RF 14% 5%
Sharpe
0.75
SD( RP )
12%
R P R F 14% 5%
15% 5%
9.00
7.69 Treynor
P
1.0
1.3
No. Because the Sharpe Ratio is lower than that for the overall market, your
portfolio is unattractive in that it offers a smaller risk premium per unit of risk
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Jensen measure
The Jensen measure, also called Jensen Alpha, or portfolio alpha
measures the average return on the portfolio over and above that
predicted by the CAPM, given the portfolios beta and the average
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Example
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Example
Que. What is the portfolio beta if a portfolio has two stocks; GM with a
beta of 1.7 and WMT with a beta of 0.6? The portfolio is divided into GM
(35%) and WMT (65%).
Ans :
we have two stocks GM and WMT. Also, portfolio weight for GM is 35%
MCQs
Q1. ______ fund managers try to replicate the performance of a
(b) Passive
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MCQs
Q2. Over pricing in a stock presents an opportunity to engage in _____
the stock.
(a) short covering
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MCQs
Q3. Investment advisory firms manage ______.
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MCQs
Q4. Average Return of an investor's portfolio is 10%. The risk free
return for the market is 8%. The Beta of the investor's portfolio is 1.2.
Calculate the Treynor Ratio.
(a) 4
(b) 8
(c) 2
(d) 6
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MCQs
Q5. Average Return of an investor's portfolio is 55%. The risk free
return for the market is 8%. The Beta of the investor's portfolio is 1.2.
Calculate the Treynor Ratio.
(a) 41
(b) 39
(c) 43
(d) 45
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3) a
4) c
5) b
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End of Module.
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