Capital Markets I – ECN226

Welcome Notes
The teaching team

• Dr. Luigi Ventimiglia

Email address: l.ventimiglia@qmul.ac.uk
Office hours:
Room: Graduate Centre 5.06
Tuesday
10:00 - 11:00 & 13:00 – 14:00

• Teaching Assistants: Tien Chuong Nguyen, Mina Mirshahi, Dennis

Iweze

2
Teaching Format

• Lectures: Tuesday 2 pm - 4pm

– We will take attendance, but it is not compulsory.

• Classes 1 hour (time depends on group) start Next week!

– Class attendance is COMPULSORY!!
– devoted to solving problem sets
– problem sets will be posted on QMLPUS in advance
– PLEASE DO PREPARE FOR THE CLASSES!!!
– (Summary) solutions will be posted after the classes

3
Overview

• Course based on Bodie Kane Marcus: the relevant reading will be

specified for each lecture

• Lecture slides on QMPLUS on Thursday

• Supplementary readings/materials available on QMPLUS
4
Assessment

• Mid-term examination: 20% of the final grade

Will be taking place on Tuesday 12th of March at 2 pm (1 hour).
More details on the structure of the examination and the material
covered in week 5

• Final examination: 80% of the final grade

Detailed discussion of the exam structure in the last week
All Past exams papers are available on QMPLUS

5
Module Overview (Topics by Week)

Finance – Key Insights

II. Expected
Return Models
Introduction (1)
I. Portfolio Theory - Equity Markets:
- The investment environment
CAPM, Index Model,
- The Net Present Value
- Risk/Return, APT, Multifactor Models
Capital Allocation (3) (5-8)
How to value bonds and stocks (2)
- Optimal Risk Portfolios, III. EMH and Behavioural
- Bonds: Price, Yield, Duration
Asset Allocation (4) Finance (9)
- Equity: Dividend Discount Model
- Predictability in
Returns

6
Pluralism in Economics

7
 Capital Markets I – ECN226

Lecture 1: The Investment Environment

Lecture 1 Overview

1. The investment environment

• Real and Financial assets
• Financial markets

2. How do we value real investments?

• Present / Future value
• The NPV rule
• Valuing annuities and perpetuities
• Simple and compound interest rates

Bodie Kane Marcus

Chapter 1: ‘The investment environment’

9
THE INVESTMENT ENVIRONMENT

10
Investments

• Investment: the current commitment of money or other resources

in the expectation of future benefits.

• Our focus: bonds and stocks but the principles we will discuss are
more general.

11
Real vs. financial assets

• Real assets: land, buildings, machines, knowledge...

– generate net income for the economy.

• Financial assets: bonds, stocks...

– do not contribute directly to the productive capacity of the economy;
– they are claims on the income generated by real assets;
– define the allocation of income among investors.

12
Real vs. Financial Assets

13
Taxonomy of financial assets

• Fixed income (or debt) securities: offer a fixed stream of

income, or a stream of income determined by a specified formula.
– Variety in terms of risk, maturities etc.

• Equity: ownership of a share of a company.

– Their performance is tied to the performance of the company.

• Derivative securities: provide payoffs that are determined by the

prices of other assets.

14
 Composition and Growth of the Global Stock of Financial Assets

250
Equity Securities
Government Debt Securities
200
Private Debt Securities
Bank Deposits
150
$ Trillion

100

50

0
1990 1995 2000 2005 2006 2007 2008 2009 2010

Source McKinsey
15
Financial Markets and the Economy, useful?

• Information role of financial markets:

– the stock market encourages allocation of capital to those firms that
appear at the time to have the best prospects.

• Consumption timing:
– shift purchasing power from high to low earnings periods.

• Allocation of risk:
– capital markets allow the risk, inherent to all investments, to be borne
by the investors most willing to bear that risk.

• Separation of ownership and management:

– the owners (shareholders) of a company do not manage the company.
– Advantage: stability.
– Disadvantage: agency problems (Corporate Finance II)
16
Markets are Competitive: no `free lunch'

• The risk-return trade-off

– Future returns can rarely be predicted precisely.
– A higher expected return comes at a price, a higher risk.
– Risk-return trade-off: higher risk assets are priced to offer a
higher expected return than lower risk assets.

• Efficient markets
– The markets process quickly and efficiently all relevant
information about securities.
– Hence the security price reflects all the information available to
investors about the value of the security.
17
The Players

• Business Firms– net borrowers of funds

• Households – net savers, purchase securities

• Governments – can be both borrowers and

savers. If in budget deficit they borrow issuing
T-bills, notes or bonds.

18
The Players (Ctd.)

• Financial Intermediaries: Pool and invest funds

– Investment Companies
– Banks
– Insurance companies
– Credit unions

19
Financialization: definition

• “Financialization means the increasing role of financial motives, financial

markets, financial actors and financial institutions in the operation of the
domestic and international economies” (Epstein 2005)

• An Heterodox (post-Keynesian) view: Western economies have moved

towards a financialization process over the last decades, with
deregulation of the regulated financial system and growth of the
unregulated financial system.

• Thus: Financial crises are an endogenous feature of unregulated

capitalism. As a result, financial crises are more frequent and more
severe.

20
Balance Sheet of a Commercial Bank

21
 Financial institutions – stylised facts

• The GDP share of the finance, insurance and real estate sectors has nearly doubled

22
 Financial institutions – stylised facts

• Annual volume of share has increased dramatically.

23
 Financial institutions - more stylised facts

• The profits of financial corporations relative to those of non-financial corporations

have doubled or tripled.
• The profits of banks as a percentage of their total assets have nearly doubled.
• Compensation of employees in the financial sector as a percentage of total
compensation in the economy has doubled.

24
 Non-financial corporations – stylized facts

• The percentage of financial assets held by non-financial corporations relative to

tangible assets has tripled, now on par.
• Non-financial corporations now raise a larger proportion of their funds through
bond issues.
• The interest and dividend income of non-financial corporations as a percentage of
their gross value added has tripled.

25
Non-Financial corporations – more stylized facts

• Non-financial corporations, that used to issue new equity to finance

their investments, now often buy back their shares instead.

26
Non-Financial corporations – stylized facts

Stock Price:

27
Distributional issues – stylized facts

• The wage share of income has gone down.

• The share of income going to rentiers has risen.
• The income share of the lowest quintile has fallen.
• The income share of the highest quintile has risen.
• There has been an incredible rise in the income share of the top
centile.

28
Balance Sheet of a U.S. household

29
You have been financialized too…

30
Asset Management Industry - The Supply and Demand of Assets

Global Equity Market Capitalization in July 2008 (50 tn) and in October 2008 (35 tn). In 2013, 64 tn
Source (http://www.world-exchanges.org)

Source: Morgan Stanley (2001)

31
 AUM of different Financial Institutions and the rise of
Hedge Funds

AuM of Different Types of Financial

Institutions in OECD Countries

14
12 Insurance
AuM (in tr. $)

10 companies
8 Pension funds
6
4 Investment
2 companies
0
19

19

19

19

19

20
90

92

94

96

98

00

Year

32
Sovereign Wealth Funds are also growing fast ($6.7 tn)

COUNTRY FUND NAME FOUNDING DATE (ORIGIN) EST. VALUE ($BN)

NORWAY GLOBAL PENSION FUND-GLOBAL 1990 (OIL) $893

UAE – ABU DHABI ABU DHABI INVESTMENT AUTHORITY 1976 (OIL) $773

SAUDI ARABIA SAMA FOREIGN HOLDINGS N/A (OIL) $737

CHINA CHINA INVESTMENT CORPORATION 2007 (NON-COMMODITY) $652

CHINA SAFE INVESTMENT COMPANY 1997 (NON-COMMODITY) $576

KUWAIT KUWAIT INVESTMENT AUTHORITY 1953 (OIL) $410

HONG KONG HK MONETARY AUTHORITY 1993 (NON-COMMODITY) $326

SINGAPORE GIC 1981 $321

… … … …

RUSSIA NATIONAL WEALTH FUND 2008 (OIL) $87

AZERBAIJAN STATE OIL FUND 1999 (OIL) $37

SOURCE: www.swfinstitute.org (2014)

33
 How do we trade?

• Primary Market
– Firms issue new securities through underwriter
to public
– Investors get new securities; firm gets funding
• Secondary Market
– Investors trade previously issued securities
among themselves

34
HOW DO WE VALUE REAL INVESTMENTS?

35
Present Value: Two basic principles

Principle 1: A pound today is worth more than a pound tomorrow

• A pound today can be enjoyed through consumption. By contrast, immobilising it
in an investment for some time means it cannot be "consumed" (i.e. enjoyed)
whenever an investor wants to do so.
• For this reason, we usually require a positive interest rate on our investments.
Such interest rate is (together with Principle 2!) a remuneration for postponing
our consumption.
• With such additional value, we are going to consume in the future more than
what we can afford today with our pound. (no inflation assumed).
• Because one pound today can be invested to yield us some additional
consumption in the future, we cannot compare it directly with a pound to be
received at a future point in time.

36
Present Value: Two basic principles

Principle 1: A pound today is worth more than a pound tomorrow

A pound today can be invested and starts earning money immediately.
In order to compare money today with money that will be received in
the future, the future money needs to be discounted.

• If 𝑪𝟏 is the expected payoff in one year, its present value is:

𝟏
𝑷𝑽 = 𝑪𝟏
𝟏+𝒓
• 𝒓 is the rate of return that investors demand for accepting delayed
payment, discount rate (more in few slides!).
𝟏
• is the discount factor.
𝟏+𝒓

37
Example

Consider an investment of $200,000 at 4% interest for one year. The

future value of the investment in one year is:
𝑭𝑽 = 𝟐𝟎𝟎, 𝟎𝟎𝟎 × 𝟏 + 𝟎. 𝟎𝟒 = 𝟐𝟎𝟖, 𝟎𝟎𝟎

Equivalently, $208,000 next year is worth less than $208,000 today.

Indeed:
𝟐𝟎𝟖, 𝟎𝟎𝟎
𝑷𝑽 = = 𝟐𝟎𝟎, 𝟎𝟎𝟎
𝟏 + 𝟎. 𝟎𝟒

What happens if the discount rate next year goes down?

38
Net Present Value

𝑪𝟏
𝑵𝑷𝑽 = + 𝑪𝟎
𝟏+𝒓

𝑪𝟏
is the Present Value of cashflows to be received one year from
𝟏+𝒓
now.
𝑪𝟎 is the initial investment, it is usually a negative number.

39
The discount rate

• The discount rate corresponds to the return offered by equivalent

investment alternatives in the capital market (i.e. investment
alternatives with the same level of risk).

• It is also defined as the opportunity cost of capital (OCC): it is the

return foregone by investing in the project rather than in an
alternative security.

40
Present Value: Two basic principles

Principle 2: A safe pound is worth more than a risky pound

• Individuals dislike risk. Hence, risky projects whose payoffs should be discounted
by higher discount rates than the rates of safe investments.
• Since investors dislike risk, they ask higher remuneration from riskier projects.
Such interest, named risk premium, is the additional remuneration investors
require for bearing risk on their investment.
• A discount rate that accounts for the riskiness of the project.
𝟏
𝑷𝑽 = 𝑪𝟏
𝟏 + 𝒓𝒇 + 𝜶

• 𝒓𝒇 is the risk-free discount rate, investors ask for the disutility they face by
postponing consumption (Principle 1). It depends on time and investors’ patience
only.
• 𝜶 is a measure of risk premium (Principle 2). The higher the risk and investors’ risk
aversion, the higher the premium 𝜶 they require as remuneration for bearing it.

41
Decision rules for capital investments

• NPV rule: accept a project if its net present value is positive.

• Rate of Return rule (RR): accept a project if its rate of return is

higher than the opportunity cost of capital.

42
Decision rules for capital investments

The second rule suggests to calculate the profit associated to the

investment as:
𝑷𝒓𝒐𝒇𝒊𝒕𝒔 = 𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔 − 𝑪𝒐𝒔𝒕𝒔

Then define the 𝑹𝑹:

𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔 − 𝑪𝒐𝒔𝒕𝒔
𝑹𝑹 =
𝑪𝒐𝒔𝒕𝒔

43
Example

• Suppose you may invest today $100,000 and that the expected payoff of
this investment is $110,000. This means that the Expected return of this
investment is:
𝟏𝟏𝟎, 𝟎𝟎𝟎 − 𝟏𝟎𝟎, 𝟎𝟎𝟎
𝑹𝑹 = = 𝟏𝟎%
𝟏𝟎𝟎, 𝟎𝟎𝟎

• Suppose that the expected return of an investment with equivalent risk

(i.e. the opportunity cost of capital) is 15%. Therefore, the 𝑷𝑽 of our
investment is obtained by discounting the expected payoff by the
opportunity cost of capital.
𝟏𝟏𝟎, 𝟎𝟎𝟎
𝑷𝑽 = = 𝟗𝟓, 𝟔𝟓𝟐
𝟏 + 𝟎. 𝟏𝟓
𝑵𝑷𝑽 = 𝟗𝟓, 𝟔𝟓𝟐 − 𝟏𝟎𝟎, 𝟎𝟎𝟎 = −𝟒, 𝟑𝟒𝟖

44
 Example

It is not worth to undertake this investment because:

• 𝑵𝑷𝑽 < 𝟎

• 𝑻𝒉𝒆 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 < 𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝟏𝟎% < 𝟏𝟓%

45
PV: More than two periods

• The present value of an asset that produces a cashflow 𝑪𝟏 , one year

from now is:
𝑪𝟏
𝑷𝑽 =
𝟏+𝒓
• The present value of an asset that produces a cashflow 𝑪𝟐 , two year
from now is:
𝟏 𝑪𝟐 𝑪𝟐
𝑷𝑽 = =
(𝟏 + 𝒓𝟐 ) (𝟏 + 𝒓𝟐 ) (𝟏 + 𝒓𝟐 )𝟐

𝒓𝟐 is the annual interest paid on the money invested for 2 years.

You have to discount twice!
46
PV: More than two periods

The present value of an asset that produces an extended stream of cashflows

is:
𝒏
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏 𝑪𝒕
𝑷𝑽 = + + + ⋯+ =
𝟏 + 𝒓 (𝟏 + 𝒓𝟐 )𝟐 (𝟏 + 𝒓𝟑 )𝟑 𝟏 + 𝒓𝒏 𝒏 (𝟏 + 𝒓𝒕 )𝒕
𝒕=𝟏
which is called the discounted cashflow (DCF) formula.

And the formula for the NPV is:

𝒏 𝒏
𝑪𝒕 𝑪𝒕
𝑵𝑷𝑽 = 𝑪𝟎 + 𝒕
=
(𝟏 + 𝒓𝒕 ) (𝟏 + 𝒓𝒕 )𝒕
𝒕=𝟏 𝒕=𝟎

47
PV: Valuing perpetuities

Perpetuities are bonds (government securities) that offer fixed income

(coupon payment C) for each year to perpetuity and there is no
obligation for the government to repay the nominal value.
𝑪 𝑪 𝑪 𝑪
𝑷𝑽 = + 𝟐
+ 𝟑
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝒏
𝑪 𝟏 𝟏 𝟏
= 𝟏+ + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏 + 𝒓 𝒏−𝟏
𝟏
setting ≡ 𝒙 yields:
𝟏+𝒓
𝑷𝑽 = 𝑪𝒙(𝟏 + 𝒙 + 𝒙𝟐 + ⋯ + 𝒙𝒏−𝟏 )

48
PV: Valuing perpetuities

As 𝒏 → ∞ and since 𝒙 < 𝟏, the sum in the brackets is a sum of an

infinite geometric progression, which equals (For a reminder: see
Appendix 1):
𝟐 𝒏−𝟏
𝟏
𝟏 + 𝒙 + 𝒙 + ⋯+ 𝒙 =
𝟏−𝒙

Hence the present value of the perpetuity becomes:

𝑪𝒙 𝟏 𝑪 𝑪
𝑷𝑽 = = ⇒ 𝑷𝑽 =
𝟏 − 𝒙 𝟏 + 𝒓𝟏 − 𝟏 𝒓
𝟏+𝒓

Remark: This formula gives the value of a regular stream of payments

starting one year from now.
49
PV: Valuing growing perpetuities

What if the stream of cashflows grows at a constant rate g? If this is

the case, the PV formula becomes:
𝑪𝟏 𝑪𝟐 𝑪𝟑 𝑪𝒏
𝑷𝑽 = + 𝟐
+ 𝟑
+ ⋯+
𝟏 + 𝒓 (𝟏 + 𝒓) (𝟏 + 𝒓) 𝟏+𝒓 𝒏

where,
𝑪𝟐 = 𝟏 + 𝐠 𝑪𝟏
𝑪𝟑 = (𝟏 + 𝒈)𝟐 𝑪𝟏
𝑪𝒏 = (𝟏 + 𝒈)𝒏−𝟏 𝑪𝟏

50
PV: Valuing growing perpetuities

𝑪𝟏 𝑪𝟏 𝟏 + 𝒈 𝑪𝟏 (𝟏 + 𝒈)𝟐 𝑪𝟏 (𝟏 + 𝒈)𝒏−𝟏
𝑷𝑽 = + 𝟐
+ 𝟑
+ ⋯+
𝟏+𝒓 𝟏+𝒓 (𝟏 + 𝒓) 𝟏+𝒓 𝒏
𝑪𝟏 𝟏+𝒈 𝟏+𝒈 𝟐 𝟏 + 𝒈 𝒏−𝟏
= 𝟏+ + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏 + 𝒓 𝒏−𝟏
𝑪𝟏 𝟏
=
𝟏 +𝒓𝟏 −𝟏 +𝒈
𝟏+𝒓

Hence the present value of a perpetuity growing at the constant rate 𝒈

is:
𝑪𝟏
𝑷𝑽 =
𝒓−𝒈
51
PV: Valuing annuities

• An Annuity is an asset that pays a fixed sum each year for a specified
number of years only (for example the mortgage of a house). In such
a case, n is not going to infinity in the following formula:
𝑪 𝟏 𝟏 𝟏
𝑷𝑽 = 𝟏+ + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏 + 𝒓 𝒏−𝟏

𝟏
setting ≡ 𝒙 yields:
𝟏+𝒓
𝑷𝑽 = 𝑪𝒙(𝟏 + 𝒙 + 𝒙𝟐 + ⋯ + 𝒙𝒏−𝟏 )

52
PV: Valuing annuities

The sum in the brackets represents the sum of a finite geometric progression
with initial value 1 and common ratio 𝒙 (See Appendix 1 for a reminder!):
𝟏 − 𝒙𝒏
𝟏−𝒙

So the present value of the annuity writes:

𝟏 𝒏
𝑪 𝟏−
𝟏+𝒓
𝑷𝑽 =
𝟏+𝒓 𝟏
𝟏−
𝟏+𝒓
𝟏 𝟏
=𝑪 −
𝒓 𝒓 𝟏+𝒓 𝒏

53
PV: Valuing annuities

Example: As a winner of a breakfast competition, you can choose to

receive $100,000 immediately, or $19,000 pounds for 10 years, starting
from next year. The discount rate is 12%.
The present value of an annuity of 19,000 for 10 years at interest rate
12% writes:
𝟏 𝟏
𝑷𝑽 = 𝟏𝟗, 𝟎𝟎𝟎 −
𝟎. 𝟏𝟐 𝟎. 𝟏𝟐(𝟏 + 𝟎. 𝟏𝟐)𝟏𝟎
= 𝟏𝟎𝟕, 𝟑𝟓𝟒
> 𝟏𝟎𝟎, 𝟎𝟎𝟎

The annuity is better than receiving the full amount of $100,000

immediately.
54
PV: Valuing growing annuities

• A growing annuity: a finite stream of cashflows growing at a rate 𝒈.

𝑪𝟏 𝑪𝟏 𝟏 + 𝒈 𝑪𝟏 (𝟏 + 𝒈)𝒏−𝟏
𝑷𝑽 = + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝒏
𝑪𝟏 𝟏+𝒈 𝟏+𝒈 𝟐 𝟏 + 𝒈 𝒏−𝟏
= 𝟏+ + 𝟐
+ ⋯+
𝟏+𝒓 𝟏+𝒓 𝟏+𝒓 𝟏 + 𝒓 𝒏−𝟏

• By applying the formula for the sum of a finite geometric

𝟏+𝒈
progression with common ration , we obtain:
𝟏+𝒓
𝟏 𝟏 (𝟏 + 𝒈)𝒏
𝑷𝑽 = 𝑪𝟏 −
𝒓 − 𝒈 𝒓 − 𝒈 (𝟏 + 𝒓)𝒏

55
Simple and Compound Interest Rate

• Simple interest rate: the interest is paid only based on the initial
investment, there is no interest on interest.

• Compound interest rate: interests are earned on the initial

investment and on the interests.

56
Simple and Compound Interest Rate

57
Simple and Compound Interest Rate

58
Simple and Compound Interest Rate

• In France and Germany, most corporations pay interests annually,

while in the US and Britain most pay interests semi-annually.

• An investment of amount 𝑨 in a bond that earns interest of 𝒓% per

annum compound semi-annually is:
𝒓 𝟐
𝑨 𝟏+
𝟐

59
Simple and Compound Interest Rate

• This can be generalized to any compounding interval.

• An investment 𝑨 at a rate 𝒓 per annum, compounded 𝒎 times a
year, yields at the end of the year:
𝒓 𝒎
𝑨 𝟏+
𝒎

• If we compound 𝒎 times a year and we consider 𝒕 years, then:

𝒓 𝒕𝒎
𝑨 𝟏+
𝒎

See Appendix 2 for the case of continuous compounding.

60
APPENDIX

61
Appendix 1: A reminder on geometric series

• Let us consider a geometric progression with initial value a and a common ratio 𝒌.
𝒂, 𝒂𝒌, 𝒂𝒌𝟐 , … , 𝒂𝒌𝒏
• The nth term writes:
𝒂𝒏 = 𝒌𝒂𝒏−𝟏
= 𝒌𝒏−𝟏 𝒂
• The sum of a finite geometric progression:
𝒏
𝒊
𝒂(𝟏 − 𝒌𝒏+𝟏 )
𝒂𝒌 =
𝟏−𝒌
𝒊=𝟎

• The sum of an infinite geometric progression, with 𝒌 < 𝟏:

𝒏
𝒂
𝒂𝒌𝒊 =
𝟏−𝒌
𝒊=𝟎

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Appendix 2: Continuous Compounding

• We saw that an investment 𝑨 at rate 𝒓 per annum, compounded

𝒎 times a year for 𝒕 years yields:
𝒓 𝒕𝒎
𝑭𝑽 = 𝑨 𝟏 +
𝒎
• This is equivalent to:
𝒓𝒕𝒎
𝒓 𝒓
𝑭𝑽 = 𝑨 𝟏 +
𝒎
• Let us make the following change of variable: 𝒓 =𝟏 .
𝒎 𝒙
Hence the future value becomes:
𝒓𝒕𝒙
𝟏
𝑭𝑽 = 𝑨 𝟏 +
𝒙
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Appendix 2: Continuous Compounding

• We want to find the future value of the investment when 𝒎 → ∞

(i.e. continuous compounding).
• First, notice that when 𝒎 → ∞ , 𝒙 → ∞ .
• Second, we know that:
𝒙
𝟏
𝐥𝐢𝐦 𝟏 + =𝒆
𝒙→∞ 𝒙
• Hence:
𝒓𝒕𝒙
𝟏
𝐥𝐢𝐦 𝑨 𝟏 + = 𝑨𝒆𝒕𝒓
𝒙→∞ 𝒙

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