Topic 1

TOPIC 1
UNDERSTANDING INVESTMENTS
& INVESTMENT ALTERNATIVES
LEARNING OBJECTIVE
1. To understand the investments field as currently practiced

2. To help you make investment decisions that will enhance
your economic welfare
3. To create realistic expectations about the outcome of
investment decisions
Example
• Suppose must invest this money intelligently in you are

fortunate enough to receive an inheritance of $1 million
from a relative. She specifies only that you must invest this
money in financial assets within the next six months.
• Other assumptions, spending on consumption or lending
out money.
INVESTMENTS DEFINED
• The term investing can cover a wide range of

activities. It often refers to investing money in
certificates of deposit, bonds, common stocks, or
mutual funds.
• Investments is the study of the process of
committing funds to one or more assets
➢Emphasis on holding financial assets and
marketable securities
➢Concepts also apply to real assets
➢Foreign financial assets should not be ignored
→ Investments is concerned with the management
of an investor’s wealth, which is the sum of current
income and the present value of all future income
1-4
WHY STUDY INVESTMENTS?
• Most individuals make investment decisions

sometime
➢Need sound framework for managing and
increasing wealth
• Essential part of a career in the field
➢Security analyst, portfolio manager, registered
representative, Certified Financial Planner,
Chartered Financial Analyst
1-5
INVESTMENT DECISIONS
• Underlying investment decisions: the tradeoff

between expected return and risk
➢Expected return is not usually the same as
realized return
• Risk: the possibility that the realized return will be
different than the expected return
➢Investor risk tolerance affects expected return
1-6
FINANCIAL ASSETS & MARKETABLE SECURITIES
• Financial assets: real assets are tangible, physical

assets such as gold, silver, diamonds, art, and real
estate
• Marketable securities are financial assets that are
easily and cheaply tradable in organized markets
THE TRADEOFF
BETWEEN EXPECTED RETURN & RISK
• Investors manage risk at a

cost - lower expected ER
returns (ER)
• Any level of expected Stocks
return and risk can be
attained Bonds
Risk-free Rate
Risk
1-8
The Investment Decision Process
• Two-step process:
➢Security analysis and valuation
✓Necessary to understand security characteristics
➢Portfolio management
✓Selected securities viewed as a single unit
✓How efficient are financial markets in processing
new information?
✓How and when should it be revised?
✓How should portfolio performance be measured?
1-9
FACTORS AFFECTING THE PROCESS
• Uncertainty in ex post returns dominates decision process

➢Future unknown and must be estimated
• Foreign financial assets: opportunity to enhance return or
reduce risk
• Quick adjustments needed to a changing environment
• The Internet and investment opportunities
• Individual and Institutional investors important
1-10
Individual and Institutional investors
• Institutional investors have a dual relationship with

individual investors. On the one hand, individuals are the
indirect beneficiaries of institutional investor actions,
because they own or benefit from these institutions’
portfolios. On a daily basis, however, they are “competing”
with these institutions in the sense that both are managing
portfolios of securities and attempting to do well financially
by buying and selling securities.
• Institutional investors are indeed the “professional”
investors, with vast resources at their command. In the
past, they were often treated differently from individual
investors, because companies often disclosed important
information selectively to some institutional investors.
QUESTIONS
1. Investors should always seek to maximize their

returns from investing. Agree or disagree?
2. What are institutional investors? How are
individual investors likely to be affected by
institutional investors?
3. “A risk-averse investor will not assume risk.”
Agree or disagree with this statement, and
explain your reasoning.
4. Distinguish between expected return and
realized return?
TOPIC 2
INDIRECT INVESTING &

SECUTIES MARKET
LEARNING OBJECTIVE
1. Appreciate the importance of indirect investing to

individual investors.
2. Distinguish between closed-end funds, mutual funds, and
exchange-traded funds.
3. Evaluate key features of mutual funds, such as the sales
charge, the management fee, and the net asset value.
4. Recognize and know how to use exchange-traded funds.
5. Distinguish between primary and secondary Markets
6. Understand how the equity markets, where stocks are
traded, are organized, how they operate, and how they
differ from each other
7. Recognize and understand the various stock market
indexes typically encountered by investors.
INDIRECT INVESTING
• Indirect investing in this discussion refers to the buying and
selling of the shares of investment companies that, in turn,
hold portfolios of securities.
• Direct versus Indirect Investing.
INDIRECT INVESTING
Closed-end investment company
• Closed-end investment company

➢ is an investment company with a fixed capitalization
whose shares trade on exchanges and OTC
➢ offers investors an actively managed portfolio of
securities
➢ To buy and sell, investors use their brokerage firms,
paying (receiving) the current price at which the shares
are selling plus (less) brokerage commissions
• Shares of closed-end funds trade on stock exchanges,
their prices are determined by investors.
Exchange traded fund (ETF)
• Generally an index fund priced and traded on

exchanges like any share of stock
Mutual Fund
• is an open-end investment company, the most

familiar type of investment company.
• Unlike closed-end funds and ETFs, mutual funds
do not trade on stock exchanges. Investors buy
mutual funds shares from investment companies,
and sell their shares back to the companies.
• The benefit of mutual fund is that it allows people
with small money, not much expertise in finance,
to diversify their portfolios and get a higher normal
return than deposit institutions such as commercial
banks.
Mutual Fund
Benefits:
• The benefit of mutual fund is that it allows people
with small money, not much expertise in finance,
to diversify their portfolios and get a higher normal
return than deposit institutions such as commercial
banks.
• Participating in mutual funds will reduce
transaction costs based on a sharing mechanism
• Investing through a mutual fund will help amateur
investors take advantage of the expertise of fund
managers, who are professionally trained in this
field.
MONEY MARKET FUNDS
• A mutual fund that invests in money market

instruments
• Are open-end investment companies whose
portfolios consist of money market instruments.
• Money Market Funds as an Investment Money
market funds (MMFs) provide investors with a
chance to earn the going rates in the money
market while enjoying broad diversification and
great liquidity. These rates have varied widely as
market conditions changed. The important point is
that their yields quickly correspond to current
market conditions.
Net Asset Value
• The Net Asset Value (NAV) is the per share value of the
securities in the fund’s portfolio.
• It is computed daily after the markets close at 4 p.m. by
calculating the total market value of the securities in the
portfolio, subtracting any liabilities, and dividing by the
number of investment company fund shares currently
outstanding.
• Assume the Titan Fund has a portfolio of stocks valued on

a given day at $50,000,000. Its liabilities are $500,000, and
shareholders of this fund own five million shares. NAV?
SECURITIES MARKETS
• A primary market
➢ is one in which an issuer seeking new funds
sells additional securities in exchange for cash
from an investor (buyer).
➢ New sales of Treasury bonds, or Apple stock,
or California bonds all take place in the primary
markets.
➢ The issuers of these securities – the U.S.
government, IBM, and the state of California,
respectively – receive cash from the buyers of
these new securities, who in turn receive new
financial claims on the issuer.
SECURITIES MARKETS
• A primary market
➢ This is the market where securities are created.
In the primary market, companies sell new
stocks and bonds to investors for the first time.
This is usually done through an Initial Public
Offering (IPO).
➢Small investors are not able to purchase
securities in the primary market because the
issuing company and its investment bankers are
looking to sell to large investors who can buy a
lot of securities at once. The primary market
provides financing for issuing companies.
SECURITIES MARKETS
• Initial Public Offering (IPO) Common stock shares

of a company being sold for the first time.
• Once the original purchasers sell the securities,
they trade in secondary markets. New securities
may trade repeatedly in the secondary market, but
the original issuers will be unaffected in the sense
that they receive no additional cash from these
transactions.
SECURITIES MARKETS
A secondary market
• This is the market wherein the trading of securities
is done. Secondary market consists of both equity
as well as debt markets.
• Or The secondary market is where investors buy
and sell securities from other investors (think of
stock exchanges).
• For example, if you want to buy Apple stock, you
would purchase the stock from investors who
already own the stock rather than Apple. Apple
would not be involved in the transaction.
SECONDARY MARKETS
• Secondary Market: the market in which securities are

traded after they have been issued
Role of Secondary Markets
➢ Provides liquidity to security purchasers
➢ Provides continuous pricing mechanism
• Securities Exchanges: forums where buyers and sellers
of securities are brought together to execute trades
• Nasdaq Market: employs an all-electronic trading platform
to execute trades
• Over-the-counter (OTC) Market: involves trading in
smaller, unlisted securities
SECURITIES MARKETS
Importance of a Secondary Market
• The secondary market helps measure the economic condition of
a country. The rise or fall in share prices indicates a boom or
recession cycle in an economy.
• The secondary market provides a good mechanism for a fair
valuation of a company.
• The secondary market helps drive the price of securities towards
their genuine, fair market value through the basic economic
forces of supply and demand.
• The secondary market promotes economic efficiency. Each sale
of a security involves a seller who values the security less than
the price and a buyer who values the security more than the
price.
• The secondary market allows for high liquidity – stocks can be
easily bought and sold for cash.
THE INVESTMENT BANKER’S ROLE
• Underwriting the Issue: purchases the security at agreed-on price
and bears the risk of reselling it to the public
• Underwriting Syndicate: group formed by investment banker to share
the financial risk of underwriting
• Selling Group: other brokerage firms that help the underwriting
syndicate sell issue to the public
• Tombstone: public announcement of issue and role of participants in
underwriting process
• Investment Banker Compensation: typically in the form of a discount
on the sale price of the securities
Broker Markets and Dealer Markets
• Broker Markets: consists of national and regional

securities exchanges
➢ 60% of the total dollar volume of all shares in U.S. stock market
trade here
➢ New York Stock Exchange (NYSE) is largest and most well-known
(but after book went to press, NYSE acquired by
IntercontinentalExchange of Atlanta)
➢ Trades are executed when a buyer and a seller are brought
together by a broker and the trade takes place directly between the
buyer and seller
• Dealer Markets: consists of both the Nasdaq OMX market
and the OTC market
➢ Trades are executed with a dealer (market maker) in the middle.
Sellers sell to a market maker at a stated price. The market maker
then offers the securities to a buyer.
• A broker executes the trade on behalf of others, a dealer trades on
their own behalf.
Figure 2.3 Broker and Dealer Markets
BROKER MARKETS
• New York Stock Exchange (NYSE)

➢Largest stock exchange—over 2,700 companies
➢Over 350 billion shares of stock traded in 2005
➢Accounts for 90% of stocks traded on exchanges
➢Specialists make transactions in key stocks
➢Strictest listing policies
• NYSE Amex (formally American Stock Exchange)
➢More than 500 companies listed
➢Major market for Exchange Traded Funds
➢Typically smaller and younger companies who cannot
meet stricter listing requirements for NYSE
Broker Markets (cont’d)
• Regional Stock Exchanges

➢Typically lists between 100–500 companies, usually
with local and regional appeal
➢Listing requirements are more lenient than NYSE
➢Often include stocks that are also listed on NYSE or
NYSE Amex
➢Best-known: Midwest, Pacific, Philadelphia, Boston,
and Cincinnati
• Options Exchanges
➢Allows trading of options
➢Best-known: Chicago Board Options Exchange (CBOE)
• Futures Exchanges
➢Allows trading of financial futures
➢Best-known: Chicago Board of Trade (CBT)
Dealer Markets
• No centralized trading floor; comprised of market

makers linked by telecommunications network
Both IPOs and secondary distributions are sold on
OTC
➢40% of the total dollar volume of all shares in U.S. stock
market trade here
➢Both IPOs and secondary distributions are sold on OTC
• Bid Price: the highest price offered by market
maker to purchase a given security
• Ask Price: the lowest price at which a market
maker is willing to sell a given security
Dealer Markets
• Nasdaq
➢Largest dealer market
➢Lists large companies (Microsoft, Intel, Dell, eBay)
and smaller companies
• Over-the-counter (OTC) Bulletin Board
➢Lists smaller companies that cannot or don’t wish to
be listed on Nasdaq
➢Companies are regulated by SEC
• Over-the-counter (OTC) Pink Sheets
➢Lists smaller companies that are not regulated by
SEC
➢Liquidity is minimal or almost non-existent
➢Very risky; many nearly worthless stocks
Alternative Trading Systems
• Third Market
➢Large institutional investors go through market
makers that are not members of a securities
exchange
➢Institutional investors (mutual funds, life insurance
companies, pension funds) receive reduced trading
costs due to large size of transactions
• Fourth Market
➢Large institutional investors deal directly with each
other to bypass market makers
➢Electronic Communications Networks (ECNs) allow
direct trading
➢ECNs most effective for high-volume, actively traded
securities
General Market Conditions
• Bull Market
➢Favorable markets
➢Rising prices
➢Investor/consumer optimism
➢Economic growth and recovery
➢Government stimulus
• Bear Market
➢Unfavorable markets
➢Falling prices
➢Investor/consumer pessimism
➢Economic slowdown
➢Government restraint
Globalization of Securities Markets
• Diversification: the inclusion of a number of
different investment vehicles in a portfolio to
increase returns or reduce risks
• Use of International Securities Improves
Diversification
➢More industries and securities available
➢Securities denominated in different currencies
➢Opportunities in rapidly expanding economies
• International Investment Performance
➢Opportunities for high returns
➢Foreign securities markets do not necessarily move
with the U.S. securities market
➢Foreign securities markets tend to be more risky than
U.S. markets
Globalization of
Securities Markets (cont’d)
• Indirect Ways to Invest in Foreign Securities

➢Purchase shares of U.S.-based multinational
with substantial foreign operations
• Direct Ways to Invest in Foreign Securities
➢Purchase securities on foreign stock
exchanges
➢Buy securities of foreign companies that trade
on U.S. stock exchanges
➢Buy American Depositary Receipts (ADRs):
dollar denominated receipts for stocks of
foreign companies held in vaults of banks
Risks of International Investing
• Usual Investment Risks Still Apply

• Government Policies Risks
➢Unstable foreign governments
➢Different laws in trade, labor or taxation
➢Different economic and political conditions
➢Less stringent regulation of foreign securities
markets
• Currency Exchange Rate Risks
➢Value of foreign currency fluctuates compared to
U.S. dollar
➢Value of foreign investments can go up and down
with exchange rate fluctuations
Trading Hours of Securities Markets
• Regular Trading Session for U.S. Exchanges

and Nasdaq
➢9:30 A.M. to 4:00 P.M. Eastern time
• Extended-Hours Electronic-Trading Sessions
➢NYSE: 4:15 to 5:00 P.M. Eastern time
➢Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time
➢Regional exchanges also have after-hours trading
sessions
➢Orders only filled if matched with identical opposing
orders
Regulation of Securities Markets
• Insider Trading
➢Use of nonpublic information about a company
to make profitable securities transactions
• Blue Sky Laws
➢Laws imposed by individual states to regulate
sellers of securities
➢Intended to prevent investors from being sold
nothing but “blue sky”
• Securities Act of 1933

➢Required full disclosure of information by companies
• Securities Act of 1934
➢Established SEC as government regulatory body
• Maloney Act of 1938
➢Allowed self-regulation of securities industry through
trade associations such as the National Association of
Securities Dealers (NASD)
• Investment Company Act of 1940
➢Created & regulated mutual funds
• Investment Advisors Act of 1940

➢Required investment advisers to make full disclosure
about their backgrounds and their investments, as well
as register with the SEC
• Securities Acts Amendments of 1975
➢Abolished fixed-commissions and established an
electronic communications network to make stock
pricing more competitive
• Insider Trading and Fraud Act of 1988
➢Prohibited insider trading on nonpublic information
• Sarbanes-Oxley Act of 2002
➢Tightened accounting and audit guidelines to reduce
corporate fraud
Basic Types of Securities Transactions
• Long Purchase
➢Investor buys and holds securities
➢“Buy low and sell high”
➢Make money when prices go up
(cont’d)
• Margin Trading
➢Uses borrowed funds to purchase securities
➢Currently owned securities used as collateral for
margin loan from broker
➢Margin requirements set by Federal Reserve Board
✓Determines the minimum amount of equity
required
✓Initial margin is the percentage (50%) of fund
acquired from investor; the balance is borrowed
from broker. It is set by Federal Reserve System.
➢Can be used for common stocks, preferred stocks,
bonds, mutual funds, options, warrants and futures
Ex:
• On $4,445 purchase with how much for margin
requirement and broker will lend?
Table 2.4 Initial Margin Requirements
for Various Types of Securities
Margin Trading
• Advantages
➢ Allows use of financial leverage
➢ Magnifies profits
• Disadvantages
➢ Magnifies losses
➢ Interest expense on margin loan
➢ Margin calls
Maintenance margin
• Maintenance margin is the minimum amount of

equity that an investor must maintain in
the margin account after the purchase has been
made/ trading position and avoid a margin call
Margin Formulas
• Basic Margin Formula
Value of securities - Debit balance

Margin =
Value of securities
V -D
=
V
• Example of Using Margin
V -D $6,500 - $1,200
Margin = = = 0.815 = 81.5%
V $6,500
Table 2.3 The Effect of Margin
Trading on Security Returns
Margin Formulas (cont’d)
• Return on Invested Capital
Total Total Market Market

current interest value of value of
- + -
Return on income paid on securities securities
invested capital received margin loan at sale at purchase
=
from a margin Amount of equity at purchase
transaction
• Example of Return on Invested Capital

Return on
invested capital $100 - $125 + $7,500 - $5,000 $2,475
= = = 0.99 = 99%
from a margin $2,500 $2,500
transaction
• Short Selling
➢Investor sells securities they don’t own
➢Investor borrows securities from broker
➢Broker lends securities owned by other
investors that are held in “street name”
➢“Sell high and buy low”
➢Investors make money when stock prices
go down
Short Selling
• Advantages
➢Chance to profit when stock price declines
• Disadvantages
➢Limited return opportunities: stock price cannot go
below $0.00
➢Unlimited risks: stock price can go up an
unlimited amount
➢If stock price goes up, short seller still needs to buy
shares to pay back the “borrowed” shares to the broker
➢Short sellers may not earn dividends
Table 2.5 The Mechanics of a Short Sale
Table 2.6 Margin Positions on Short Sales
1
Risk & Rates of Return

TOPIC 3
4
Interest Rate
Interest rate represents the cost of money
It is the opportunity cost of money:
❖It shows the return lost from not investing in a
comparable risk investment.
❖It is expected to compensate the investor for the time,
inflation, and risk.
5
Interest Rates
Conceptually:
6
Interest Rates
Conceptually:
Nominal
risk-free
Interest
Rate
krf
7
Interest Rates
Conceptually:
Nominal
risk-free
Interest =
Rate
krf
8
Interest Rates
Conceptually:
Nominal Real
risk-free risk-free
Interest = Interest
Rate Rate
krf k*
9
Interest Rates
Conceptually:
Nominal Real
risk-free risk-free
Interest = Interest +
Rate Rate
krf k*
10
Interest Rates
Conceptually:
Nominal Real Inflation-
risk-free risk-free risk
Interest = Interest + premium
Rate Rate
IRP
krf k*
11
Interest Rates
Conceptually:
Rate Rate
IRP
krf k*
Mathematically:
12
Interest Rates
Conceptually:
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
13
Interest Rates
Conceptually:
Rate Rate
IRP
krf k*
Mathematically:
(1 + krf) = (1 + k*) (1 + IRP)
This is known as the “Fisher Effect”
14
Interest Rates
Suppose the real rate is 3%, and the

nominal rate is 8%. What is the inflation
rate premium?
15
Term Structure of Interest Rates
The pattern of rates of return for debt

securities that differ only in the length
of time to maturity.
16

yield
to
maturity
time to maturity (years)

17
yield
to
maturity

18
The yield curve may be downward sloping or

“inverted” if rates are expected to fall.
yield
to
maturity

19
The yield curve may be downward sloping or

“inverted” if rates are expected to fall.
yield
to
maturity

20
For a Treasury security, what is the
required rate of return?
21
For a Treasury security, what is

the required rate of return?
Required
rate of =
return
22
For a Treasury security, what is

the required rate of return?
Required Risk-free
rate of = rate of
return return
Since Treasuries are essentially free of default

risk, the rate of return on a Treasury security
is considered the “risk-free” rate of return.
23
For a corporate stock or bond, what is the
24
Required
rate of =
return
25
Required Risk-free
rate of = rate of
return return
26
Required Risk-free Risk

rate of = rate of + premium
return return
How large of a risk premium should we require

to buy a corporate security?
27
Returns
Expected Return - the return that an

investor expects to earn on an asset,
given its price, growth potential, etc.
Required Return - the return that an

investor requires on an asset given
its risk and market interest rates.
28
Risk and Rates of Return
Holding Period return
29
Pt + Dt
= ---------- - 1
Pt-1
30
Pt + Dt
= ---------- - 1
Pt-1
(Pt - Pt-1) + Dt
= ----------------
Pt-1
31
Một nhà đầu tư mua cổ phiếu của REE đầu năm 2004 với
tổng số tiền 50 triệu đồng. Trong 3 năm, mỗi năm nhà
đầu tư nhận được 5 triệu đồng cổ tức. Năm 2005, nhà
đầu tư có quyền mua cổ phiếu và đã bán, thu được 10
triệu đồng. Cuối năm 2006, nhà đầu tư đã bán toàn bộ cổ
phiếu với giá 100 triệu đồng. Nếu không tính phí giao
dịch, kết quả kinh doanh của nhà đầu tư sẽ là:
Lợi nhuận tuyệt đối là: (100 + 5 × 3 + 10) – 50 = 75 triệu
đồng
Tỷ lệ hoàn vốn là: HPR = (100+15+10)/50 = 2.5 = 250%
Lợi tức của ba năm là: HPY = 75/50 = 1,5 lần = 150%
Lợi tức mỗi năm là: HPYtheo năm = HPY1/n = 1,51/3 =
1,224745
32
Expected Return
❖Expected return is based on expected cash flows (not
accounting profits)
Return can be expressed as Cash
Flows or Percentage Return
33
Expected Return
accounting profits)
❖In an uncertain world future cash flows are not known
with certainty
34
Expected Return
accounting profits)
❖In uncertain world future cash flows are not known with
certainty
❖To calculate expected return, compute the weighted
average of all possible returns
35
Expected Return
accounting profits)
certainty
average of possible returns
❖Calculating Expected Return:
N
k=  k iP( k i )
i=1
36
Expected Return
accounting profits)
certainty
average of possible returns
❖Calculating Expected Return:
N
k=  k iP( k i )
i=1
where
ki = Return state i
P(ki) = Probability of ki occurring
N = Number of possible states
37
The expected return is a tool used to determine

whether an investment has a positive or negative
average net outcome. The sum is calculated as
the expected value (EV) of an investment given
its potential returns in different scenarios, as
illustrated by the following formula:
Expected Return = SUM (Returni x Probabilityi)
where: "i" indicates each known return and its
respective probability in the series
38
Expected Return Calculation
Example
You are evaluating ElCat Corporation’s common stock. You
estimate the following returns given different states of the
economy
State of Economy Probability Return
Economic Downturn .10 –5%
Zero Growth .20 5%
Moderate Growth .40 10%
High Growth .30 20%
39
Example
economy
Economic Downturn .10 x –5% = –0.5%
Zero Growth .20 5%
High Growth .30 20%
N
k =  k iP(k i )
i =1
40
Example
economy
Zero Growth .20 x 5% = 1%
High Growth .30 20%
N
k =  k iP(k i )
i =1
41
Example
economy
Moderate Growth .40 x 10% = 4%
High Growth .30 20%
N
k =  k iP(k i )
i =1
42
Example
economy
High Growth .30 x 20% = 6%
N
k =  k iP(k i )
i =1
43
Example
economy
k = 10.5%
N
k =  k iP(k i )
i =1
44
Example
economy
k = 10.5%
N
k =  k iP(k i ) Expected (or average) rate
i =1 of return on stock is 10.5%
45
Expected Return
For example, assume two hypothetical

investments exist. Their annual performance
results for the last five years are:
Investment A: 12%, 2%, 25%, -9%, and 10%
Investment B: 7%, 6%, 9%, 12%, and 6%
47
Risk
❖Risk is the uncertainty of future outcomes
48
Risk
Example
You evaluate two investments: ElCat Corporation’s
common stock and a one year Gov't Bond paying 6%. The
return on the Gov't Bond does not depend on the state of
the economy--you are guaranteed a 6% return.
49
Risk
Example
You evaluate two investments: ElCat Corporation’s common
stock and a one year Gov't Bond paying 6%. The return on
the Gov't Bond does not depend on the state of the economy-
-you are guaranteed a 6% return.
Probability
of Return T-Bill
100%
6% Return
50
Risk
Example
Probability T-Bill Probability ElCat Corp

of Return of Return
100%
40%
30%
20%
10%
6% Return –5% 5% 10% 20% Return
51
Risk
Example
Probability T-Bill Probability ElCat Corp

of Return There is risk in of
Owning
Return ElCat stock,
100% no risk in owning the Treasury Bill
40%
30%
20%
10%
6% Return –5% 5% 10% 20% Return
52
Measuring Risk
❖Standard Deviation (s) measure the dispersion of
returns.
53
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
54
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Compute the standard deviation on ElCat common stock.
the mean (k) was previously computed as 10.5%
55
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Economic Downturn .10 –5%
Zero Growth .20 5%
High Growth .30 20%
56
Measuring Risk
returns.
N
s=  (k i − k ) 2
P(k i )
i =1
Example

Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2
Zero Growth .20 5%
High Growth .30 20%
57
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example

Zero Growth .20 x ( 10% – 10.5%)2 = 6.05%2
High Growth .30 5%
58
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
Moderate Growth .40 x ( 10% – 10.5%)2 = 0.10%2
High Growth .30 20%
59
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Economic Downturn .10 x ( –5% – 10.5%)2 = 24.025%2– --
Zero Growth .20 x ( 5% 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
60
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
61
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
s = 57.25%2
62
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
s = 57.25%2
s = 7.57%
63
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
Higher standard deviation, higher risk s = 57.25%2
s = 7.57%
64
Measuring Risk
returns. NOTE: The
N standard
s=  (k i − k ) 2
P(k i ) deviation of the
T-Bill is 0%
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
s2 = 57.25%2
Higher standard deviation, higher risk s = 57.25%2
s = 7.57%
65
Measuring Risk
returns.
N
s=  i
(k − k ) 2
P(k i )
i =1
Example
Zero Growth .20 x ( 5% – 10.5%)2 = 6.05%2
High Growth .30 x ( 20% – 10.5%)2 = 27.075%2
Can compare the s of 7.57 to another s2 = 57.25%2

s = 57.25%2
stock with expected return of 10.5% s = 7.57%
66
Measuring Risk
Standard Deviation (s) for historical data can be used
to measure the dispersion of historical returns.
N
1
s= 
(n − 1) _ i =1
( ki − k ) 2
67
Use the following data to calculate the historical return
of XYZ
Year Return
1992 12%
1993 16%
1994 -8%
1995 6%
68
Risk and Diversification
❖Risk of a company's stock can be separated into two
parts:
69
parts:
❖Firm Specific Risk - Risk due to factors within the firm
70
parts:
Stock price will most likely fall if a major government
contract is discontinued unexpectedly.
71
parts:
❖Market related Risk - Risk due to overall market
conditions
72
parts:
conditions
Stock price is likely to rise if overall stock market is
doing well.
73
parts:
conditions
❖Diversification: If investors hold stock of many
companies, the firm specific risk will be canceled out:
Investors diversify portfolio.
74
parts:
conditions
Firm specific risk also called diversifiable
risk or unsystematic risk
75
parts:
conditions
❖Even if hold many stocks, cannot eliminate the market
related risk
76
parts:
conditions
❖Even if hold many stocks, cannot eliminate the market
related risk Market related risk is also called non-diversifiable
risk or systematic risk
77
❖If an investor holds enough stocks in portfolio (about
20) company specific (diversifiable) risk is virtually
eliminated
78
eliminated
Variability
of Returns
Market
Related Risk
Number of stocks in Portfolio
79
eliminated
Variability
of Returns
Firm Specific
Risk

80
eliminated
Variability
of Returns
Total
Risk

81
eliminated
Variability
of Returns
20
82
eliminated
❖Holding a general stock mutual fund (not a specific
industry fund) is similar to holding a well-diversified
portfolio.
Variability
of Returns
20
83
Measuring Market Risk
❖Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
84
❖Market risk is the risk of the overall market. To
measure the market risk we need to compare
individual stock returns to the overall market returns.
❖A proxy for the market is usually used: An index of
stocks such as the S&P 500
85
❖Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to
the overall market returns.
❖Market risk measures how individual stock returns are
affected by this market
86
❖Market risk is the risk of the overall market, so to
measure need to compare individual stock returns to
the overall market returns.
❖Market risk measures how individual stock returns are
affected by this market
❖Regress individual stock returns on Market index
87
PepsiCo 15%
Return
10%
5%
S&P
Return
-15% -10% -5% 5% 10% 15%
-5%
-10%
-15%
88
PepsiCo 15%
Return
10%
5%
S&P
Return
-15% -10% -5% 5% 10% 15%
Jan 1992 -5%

PepsiCo -0.37%
S&P -1.99%
-10%
-15%
89
PepsiCo 15%
Return
10%
5%
S&P
Return
-15% -10% -5% 5% 10% 15%
-5%
Plot Remaining
Points -10%
-15%
90
PepsiCo 15%
Return
10%
Fit Regression
Line 5%
S&P
Return
-15% -10% -5% 5% 10% 15%
-5%
-10%
-15%
91
PepsiCo 15%
Return
10%
5%
S&P
Return
-15% -10% -5% 5% 10% 15%
-5%
-10%
rise 5.5%
Slope = = = 1.1
run 5%
-15%
92
❖Market Risk is measured by Beta
93
❖Beta is the slope of the characteristic line
PepsiCo 15%
Return
10%
5%
S&P
Return
-15% -10% -5% 5% 10% 15%
-5%
-10%
rise 5.5%
Slope = = = 1.1 = Beta (b)
run 5%
-15%
94
❖Interpreting Beta
❖Beta = 1
Market Beta = 1
Company with a beta of 1 has average risk
95
❖Beta = 1
Market Beta = 1
❖Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
96
❖Beta = 1
Market Beta = 1
❖Beta < 1
Low Risk Company
Return on stock will be less affected by the market than average
❖Beta > 1
High Market Risk Company
Stock return will be more affected by the market than average
97
Required Minimum rate of return necessary to

Rate of = attract investors to buy funds
Return
98

Return
Required rate of return, K, depends on the risk-free

rate(Krf) and the risk premium(Krp)
99

Return

Using the capital asset pricing model (CAPM) the risk
premium(Krp) depends on market risk
100

Return

Using the capital asset pricing model (CAPM) the risk
premium(Krp) depends on market risk
Security Market Line
Kj = Krf + bj ( Km – Krf )
where:
Kj = required rate of return on the jth security
Bj = Beta for the jth security
101
Example:
If the expected return on the market is 12% and the risk
free rate is 5%:
102
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
103
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
10%
5%
Risk Free Rate
.50 1.0 1.5 Beta

104
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
12%
10% Risk & Return
on market
5%
.50 1.0 1.5 Beta

105
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
Market
10%
Connect Points for

5% Security Market Line
.50 1.0 1.5 Beta

106
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
If b of security j =1.2
Market
10%
5%
.50 1.0 1.5 Beta

107
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
5%
.50 1.0 1.2 1.5 Beta

108
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
13.4% j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
=13.4%
5%
.50 1.0 1.2 1.5 Beta

109
Example:
free rate is 5%:
Kj = 5% + bj (12% – 5% )
15%
SML
13.4% j If b of security j =1.2
Market
10% Kj = 5%+1.2(12% – 5%)
=13.4%
5% If b = 1.2, investors will
require a 13.4% return
on the stock
.50 1.0 1.2 1.5 Beta
110
ki : Expected (or required) rate of return from an
investment i.
KRF : Risk free rate of return (e.g., 3 moth T-Bill rate)
kM : Expected return from a market (e.g., S&P500)
portfolio
(kM - kRF) : Market Risk Premium
b(kM - kRF) : Risk Premium on asset i
111
Portfolio Return = S wi x ki
Return of a portfolio is the weighted average return of

individual securities in the portfolio.
Portfolio beta = S wi x bi
Beta of a portfolio is the weighted average beta of
individual securities in the portfolio.
REVIEW TOPIC 5
• Capital Market Theory: Capital market theory is a generic term
for the analysis of securities. In terms of trade off between the
returns sought by investors and the inherent risks involved, the
capital market theory is a model that seeks to price assets, most
commonly, shares.
• Market efficiency: Market efficiency refers to the degree to
which market prices reflect all available, relevant information. If
markets are efficient, then all information is already incorporated
into prices, and so there is no way to "beat" the market because
there are no undervalued or overvalued securities available.
→perfectly (everyone receives the information), completely
(everyone receives the entire information), instantly (everyone
receives the information at once), and for no cost (everyone
receives the information for free).
→The Weak, Strong, and Semi-Strong Efficient Market
Hypotheses
TOPIC 6
BOND YIELDS AND PRICES

LEARNING OBJECTIVE
1. Discuss the general features, yields, prices, popular types

of corporate bonds.
2. Understand the key inputs and basic model used in the
valuation process
3. Basic valuation model to bonds and describe the impact
of required return and time to maturity on bond values.
4. Explain the yield to maturity (YTM), its calculation, and
the procedure used to value bonds that pay interest
semiannually.
BOND VALUATION
1.Interest rate and required return

2.Corporate bond
3.Bond valuation
INTEREST RATE AND RETURN
Interest rate
Usually applied to debt instruments such as bank loans

or bonds; the compensation paid by the borrower of
funds to the lender; from the borrower’s point of view, the
cost of borrowing funds
Required return
Usually applied to equity instruments such as common

stock; the cost of funds obtained by selling an
ownership interest.
Inflation
A rising trend in the prices of most goods and services.
Liquidity preference
A general tendency for investors to prefer short-term (that is,
more liquid) securities
NOMINAL OR ACTUAL RATE OF INTEREST
The nominal rate of interest is the actual rate of

interest charged by the supplier of funds and paid by the
demander.
Real rate of interest: The rate that creates equilibrium

between the supply of savings and the demand for
investment funds in a perfect world, without inflation,
where suppliers and demanders of funds have no
liquidity preferences and there is no risk
Ex:
Lan wants to buy a doll from a shop. The shop has just
displayed the doll and it has only one doll is priced 100,000
VND. However, Lan saved 70,000 VND. And after every
month, if no one has bought the doll, the price of the doll will
be reduced by 10% compared with its price the previous
month. If no one has bought the doll, how many months at
least will Lan have to wait to buy the doll with the money she
has saved?
What are Bonds?
• A bond is a debt instrument that provides a

periodic stream of interest payments to investors
while repaying the principal sum on a specified
maturity date.
• A bond’s terms and conditions are contained in a
legal contract between the buyer and the seller,
known as the indenture.
• The valuation of a bond depends on the size of its
coupon payments, the length of time remaining
until the bond matures and the current level of
interest rates.
What are Bonds?
•A bond is a formal contract to repay borrowed

money with interest at fixed intervals.
•A bond provides the borrower with external

funds to:
– finance long term investments (for corporations)
– finance current expenditures (for municipal, state
or national governments).
BOND CHARACTERISTICS
• Buyer of a newly issued coupon bond is lending
money to the issuer who agrees to repay principal
and interest
• Bonds are fixed-income securities
➢Buyer knows future cash flows
➢Known interest and principal payments
• If sold before maturity price will depend on interest
rates at that time
2-12
BOND CHARACTERISTICS
• Prices quoted as a % of par value

• Bond buyer must pay the price of the bond
plus accrued interest since last semiannual
interest payment
➢Prices quoted without accrued interest
• Premium: amount above par value
• Discount: amount below par value
2-13
Types of bonds
• Corporate Bonds – Issued by Corporations to
expand or finance a project, usually taxable and
offer higher returns.
• Government Bonds – Treasury bonds carry the
lowest degree of risk and are the benchmark
against which all other types of bonds are
measured. Although their market values fluctuate,
they are considered the safest.
• Municipal Bonds – Issued by the local
government usually to finance specific projects.
• Other terminologies – Agency bonds,
Collateralized bonds, Commercial papers,
Convertible bonds, Covenant bonds, Credit
Rating, Debentures
Corporate bond
A bond is a long-term debt instrument that pays the
bondholder a specified amount of periodic interest rate over a
specified period of time
The bond’s coupon
The bond’s maturity
The bond’s principal is the rate is the specified
date is the time at
amount borrowed by the interest rate (or $
which a bond
company and the amount amount) that must
becomes due and
owed to the bond holder on be periodically paid.
the principal must be
the maturity date.
repaid.
Corporate bond
a) Face/Par Value
The face value (also known as the par value) of a bond is the
price at which the bond is sold to investors when first issued; it
is also the price at which the bond is redeemed at maturity. In
the U.S., the face value is usually $1,000 or a multiple of
$1,000.
b) Coupon Rate (coupon yield)

The periodic interest payments promised to bond holders are
computed as a fixed percentage of the bond’s face value; this
percentage is known as the coupon rate.
Annual coupon payments (CP)

Coupon rate =
Face value
Corporate bond
c) Coupon
A bond’s coupon is the dollar value of the periodic interest
payment promised to bondholders; this equals the coupon rate
times the face value of the bond.
For example, if a bond issuer promises to pay an annual
coupon rate of 5% to bond holders and the face value of the
bond is $1,000, the bond holders are being promised a coupon
payment of (0.05)($1,000) = $50 per year.
d) Maturity
A bond’s maturity is the length of time until the principal is
scheduled to be repaid. Occasionally a bond is issued with a
much longer maturity. There have also been a few instances
of bonds with an infinite maturity; these bonds are known
as consols. With a consol, interest is paid forever, but the
principal is never repaid.
Corporate bond: Bond Yields
• A bond’s yield or rate of return is frequently used to
assess its performance over a given period, typically 1
year.
• The three most widely cited yields are:
➢ Current yield
➢ Yield to maturity (YTM)
➢ Yield to call (YTC)

Corporate bond - Bond Yields
The bond’s current yield is the annual interest (income)

divided by the current price of the security
The bond’s yield-to-maturity is the yield (expressed as a

compound rate of return) earned on a bond from the time it
is acquired until the maturity date of the bond
A yield curve graphically shows the relationship between

the time to maturity and yields for debt in a given risk class
Corporate bond: Bond Prices
Because most corporate bonds are purchased and held by

institutional investors, bond trading and price data is not
readily available to individuals.
Although most corporate bonds are issued with a par or face

value of $1,000, all bonds are quoted as a percentage of par.
The price a dealer will pay to purchase a bond calling bid

price.
Corporate bond: Example
BOND RATINGS
• Rate relative probability of default
• Rating organizations
➢Standard and Poors Corporation (S&P)
➢Moody’s Investors Service Inc
• Rating firms perform the credit analysis for the
investor
• Emphasis on the issuer’s relative probability of
default
Corporate bond: Bond Rating
Corporate bond: Bond Rating
Corporate bond: Common types of bonds
• Zero- (or low-) coupon bonds

• Junk bonds
• Floating-rate Bond
• Extendible notes
• Putable bonds
Zero- (or low-) coupon bonds
• Issued with no (zero) or a very low coupon (stated
interest) rate and sold at a large discount from
par.
• The price of a zero-coupon bond can be
calculated by using the following formula:
M P = price
P=
(1+r)n M = maturity value
r = investor's required annual yield
n = number of years until maturity
FOR EXAMPLE
• If you want to purchase a Company XYZ zero-

coupon bond that has a $1,000 face value and
matures in three years, and you would like to earn
10% per year, compounded semiannual on the
investment, How much you willing to pay for this
bond today?
Junk bonds
• Debt rated Ba or lower by Moody’s or BB or lower
by Standard & Poor’s.
• High-risk bonds with high yields – often yielding
2% to 3% more than the best-quality corporate
debt
Floating-rate bonds
• Stated interest rate is adjusted periodically within stated
limits in response to changes in specified money market or
capital market rates. Popular when future inflation and
interest rates are uncertain.
• Ex: An investor buys a bond with an interest rate of 8% of
the adjustment period of 6 months while a government
bond has a fixed interest rate of 7.5%. After a period when
the government bond interest rate is increased to 8.5%,
after 6 months, the bond A owned will be adjusted the
interest rate at least to 9% to still ensure that A enjoys a
higher interest rate than 0, 5% compared to when
investing in government bonds → Floating-rate bonds
Extendible notes
• Short maturities, typically 1 to 5 years, that can be
renewed for a similar period at the option of
holders.
• Similar to a floating-rate bond. An issue might be a
series of 3-year renewable notes over a period of
15 years; every 3 years, the notes could be
extended for another 3 years, at a new rate
competitive with market interest rates at the time
of renewal.
Putable bonds
• Bonds that can be redeemed at par
(typically, $1,000) at the option of their
holder either at specific dates after the date
of issue and every 1 to 5 years thereafter or
when and if the firm takes specified actions,
such as being acquired, acquiring another
company, or issuing a large amount of
additional debt.
VALUATION FUNDAMENTALS
❖ The (market) value of any investment asset is simply the

present value of expected cash flows.
❖ The interest rate that these cash flows are discounted at

is called the asset’s required return.
❖ The required return is a function of the expected rate of

inflation and the perceived risk of the asset.
❖ Higher perceived risk results in a higher required return

and lower asset market values.
Bond Valuation
BASIC BOND VALUATION

𝒏
𝟏 𝑴
𝑩𝟎 = 𝑰 ෍ +
𝒕=𝟏
(𝟏 + 𝒓𝒅 )𝒕 (𝟏 + 𝒓𝒅 )𝒏
Bond Valuation
BASIC BOND VALUATION
Tim Sanchez wishes to determine the current value

of the Mills Company bond. Assuming that interest
on the Mills Company bond issue is paid annually
and that the required return is equal to the bond’s
coupon interest rate, I = $100, rd= 10%, M =
$1,000, n = 10 years. Jan 1, 2013 issuing date.
Bond Valuation
Bond Values for Various Required Returns (Mills Company’s 10%

Coupon Interest Rate, 10-Year Maturity, $1,000 Par, January 1, 2010,
Issue Paying annual Interest)
Bond Valuation
Bond values and Requires return
Discount: the amount by
which a bond sells at a
value that is less than its
par value
Premium: The amount by

which a bond sells at a
value that is greater than
its par value
Bond Valuation
Time to Maturity
and Bond values

Yield to Maturity (YTM)
Bond Valuation
➢ The yield to maturity measures the compound annual
return to an investor and considers all bond cash flows. It is
essentially the bond’s IRR based on the current price.
➢ Note that the yield to maturity will only be equal if the bond
is selling for its face value ($1,000).
➢ And that rate will be the same as the bond’s coupon rate.
✓ For premium bonds, the current yield > YTM.
✓ For discount bonds, the current yield < YTM.
Yield to Maturity (YTM)
Bond Valuation
The Mills Company bond, which currently sells for $1,080, has
a 10% coupon interest rate and $1,000 par value, pays interest
annually, and has 10 years to maturity. What is the bond’s
YTM?
𝐶𝐹 ≈ 𝐼 1 𝑀
𝐵0 = 𝑥 1− 𝑛
+
𝑌𝑇𝑀 (1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)𝑛
$100 $100 $1000

≈ 1080 = − 10
+
𝑌𝑇𝑀 𝑌𝑇𝑀(1 + 𝑌𝑇𝑀) (1 + 𝑌𝑇𝑀)10
Rd = 3%/year
YTM formula
M − B0
I+
YTM = n
M + B0
2
Simple yield calculation - example
▪ Question:
A four-year bond has exactly four years till maturity
and the last coupon has just been paid. The coupon is
annual and equal to 5.5 percent. The bond price is 96
percent.
Calculate its simple yield.
Simple yield calculation - example
▪ Question:
A four-year bond has exactly four years till maturity
and the last coupon has just been paid. The coupon is
annual and equal to 5.5 percent. The bond price is 96
percent.
Calculate its simple yield.
DURATION
• In simple terms, modified duration gives an idea of
how the price of a bond will be affected should
interest rates change. A higher duration implies
greater price sensitivity upwards (downwards)
should rates move down (up).
• Duration is quoted as the percentage change in
price for each given percent change in interest
rates. For example, the price of a bond with a
duration of 2 would be expected to increase
(decline) by about 2.00% for each 1.00% move
down (up) in rates.
DURATION
• The duration of a bond is primarily affected by its coupon
rate, yield, and remaining time to maturity. The duration of
a bond will be higher the lower its coupon, lower its yield,
and longer the time left to maturity. The following scenarios
of comparing two bonds should help clarify how these
three traits affect a bond’s duration:
✓If the coupon and yield are the same, duration increases
with time left to maturity
✓If the maturity and yield are the same, duration increases
with a lower coupon
✓If the coupon and maturity are the same, duration
increases with a lower yield
Example:
• 5.00% Coupon Bond at Par: Price Change for a Given

Rise in Rates
If Rates 2-Year 10-Year 30-Year

Move Up ... Bond Bond Bond
1.00% -1.0% -6.9% -13.7%
2.00% -1.9% -13.2% -24.7%
3.00% -2.8% -19.0% -33.6%

Exercise 1
a. What is the price of a 5-year bond with a
nominal value of $100, a yield to maturity of
7% (with annual compounding frequency), a
10% coupon rate and an annual coupon
frequency?
b. Same question for a yield to maturity of
8%, 9% and 10%. Conclude.
Exercise 2
The U.S. Treasury offers to sell you a bond for

$613.81. No payments will be made until the bond
matures 10 years from now, at which time it will be
redeemed for $1,000. What interest rate would you
earn if you bought this bond at the offer price?
Exercise 3
• Suppose a bond has a $1,000 face value, 20

years to maturity, an 8 percent coupon rate,
and a yield of 9 percent. What’s the price of
semiannual coupons bond?
• The meaning of 10% semiannual coupons?

→ Means that the bond pays coupon at 10% of
face value per year compounded semiannually.
So the rate is 5% per semiannual period which is
used to pay coupon at end of each half year.
Exercise 4
• What is the price of a 5-year bond with a

nominal value of $100, a yield to maturity of
7% (with annual compounding frequency), a
10% coupon rate and an annual coupon
frequency?
Exercise 5
• We consider the following zero-coupon curve:
Maturity (years) Zero-Coupon Rate (%)

1 4.00
2 4.50
3 4.75
4 4.90
5 5.00
1. What is the price of a 5-year bond with a $100

face value, which delivers a 5% annual coupon rate?
2. What is the yield to maturity of this bond?
Exercise 6
• We consider 2 bonds with following features:
Bond Maturity (years) Coupon Rate (%) Price YTM (%)

Bond 1 10 10 1,352.2 5.359
Bond 2 10 5 964.3 5.473
• These two bonds have a $1,000 face value, and

an annual coupon frequency. An investor buys
these two bonds and holds them until maturity.
Compute the annual return rate over the period,
supposing that the yield curve becomes
instantaneously flat at a 5.4% level and remains
stable at this level during 10 years
Exercise 7
• We are now in 31/12/2015 and you have information on
some government bonds. Their face value is EUR100 and
they all pay coupons on December 31st each year. They
already paid the coupon this year.
Bond Maturity Coupon rate

A 31/12/2016 15%
B 31/12/2018 8%
C 31/12/2020 9%
• The following spot rate: r01=6.5%; r02=6.6%; r03=6.7%;

r04=6.8%; r05= 7%
Calculate: value of bonds; YTM of three bonds
Exercise 8
1. What is the price of a 5-year bond with a

nominal value of $100, a yield to maturity of 7%
(with annual compounding frequency), a 10%
coupon rate and an annual coupon frequency?
2. Same question for a yield to maturity of 8%,
9% and 10%. Conclude.
Exercise 9
• We consider the following zero-coupon curve:
Maturity (years) Zero-Coupon Rate (%)

1 4.00
2 4.50
3 4.75
4 4.90
5 5.00
1. What is the price of a 5-year bond with a $100 face value, which
delivers a 5% annual coupon rate?
2. What is the yield to maturity of this bond?
3. We suppose that the zero-coupon curve increases instantaneously
and uniformly by 0.5%. What is the new price and the new yield to
maturity of the bond? What is the impact of this rate increase for the
bondholder?
Major Differences Among Bond Markets
▪ Quotation
▪ Bonds are quoted in the form of a clean price net of
accrued interest.
▪ The full price (or value) of a bond is the sum of its
clean price plus accrued interest. Or,
P = Q +AI
➢ Where P = full price, Q = quoted price and AI
= accrued interest
▪ Accrued interest = Coupon * (days since last
coupon date/days in coupon period).
Full Price and Clean Price – An example
▪ Question: The clean price of a Eurobond is quoted at

Q=96%. The annual coupon is 5 percent, and we are
exactly four months from the past coupon payment.
What is the full price of the bond?
Major Differences Among Bond Markets
▪ Yield to Maturity:
▪ The yield to maturity (YTM) – (lãi suất đáo hạn) is the
average promised yield over the life of the bond.
▪ The convention used to calculate YTM varies across
markets.
▪ In the U.S, YTM is calculated at a semiannual rate and the
result is multiplied by 2 to report an annualized rate.
▪ Most Europeans calculate an annual, actuarial YTM.
▪ The simple interest yield approach is also used in Japan.
Return on Foreign Bond Investments
▪ The return from investing in a foreign bond has three
components:
▪ During the investment period, the bondholder receives the
foreign yield.
▪ A change in the foreign yield (Δforeign) induces a
percentage capital gain/loss on the price of the bond.
▪ A currency movement induces a currency gain or loss on the
position.
Return = Foreign yield – D * (Δforeign yield) + % currency
movement
Currency-Hedging Strategies
▪ Foreign investments can be hedged against currency risk

by selling forward currency contracts for an amount equal
to the capital invested.
Hedged Return = Foreign yield – D * (Δforeign yield) +

Domestic cash rate – Foreign cash rate
Currency-Hedging Strategies - Example
▪ You are British and hold a U.S. Treasury bond with a full
price of 100 and duration of 15. Its yield is 6 percent. The
dollar cash rate is 3 percent, and the pound cash rate is 4
percent. You expect U.S. yields to move down by 15
basis points over the year. Give a rough estimate of your
expected return if you decide to hedge the currency risk.
A Swiss investor has purchased a US. Treasury bond priced at 100. Its yield is
4.5 percent, and the investor expects the U.S. yields to move down by 15 basis
points over the year. The duration of the bond is 6. The Swiss franc cash rate is
1 percent and the dollar cash rate is 2 percent. The one-year forward exchange
rate is USD/SFr = 1.4600
a. The Swiss investor has come up with his own model to forecast the USD/SFr
exchange rate one year ahead. This model forecasts the one-year ahead
exchange rate to be USD/SFr = 1.3500. Based on this forecast, should the
Swiss investor hedge the currency risk of his investment using a forward
contract?
b. If the Swiss investor decides to hedge using a forward contract, give a rough
estimate of his expected return.
c. Verify for the hedged investment that the risk premium in Swiss francs is the
same as the risk premium on the same U.S. Treasury bond for a US. investor.
Ex
• A government bond has a yield of 8% and an expected market

return is 15%, the beta of the portfolio with the same risk level is
0.8.
a) Apply CAPM model to calculate the expected return of
investors.
b) Investors intend to buy the bonds of Retec company in the
market with the following information: the bond has par value
of 100,000 GBP; and has coupon rate of 9% per anual. The
number of years to maturity are 15 years. Calculate the
maximum price of this bond that investors can invest in?
Chapter 5
Stock valuation
Learning goal
- Differentiable between equity and debt
- Features of both common and preferred stock
- Describe the process of issuing common stock,
- Understand the basic stock valuation using zero-growth,
constant-growth, and variable-growth models.
- Discuss free cash flow valuation model
- Explain the relationships among financial decisions,
return, risk, and the firm’s value.
- International stock market
Stock valuation
1. Differences between Debt and Equity
2. Common and Preferred stock
3. Issuing common stock
4. Common stock valuation

Differences between Debt and Equity
DEBT EQUIITY
- Bonds - Funds provided by the
- Payment firm’s owners
- Borrowing incurred by
the firm
Voice in management
Claims on income and assets
Maturity
Tax treatment
DEBT EQUIITY
Voice in management
Claims on Income and Assets
First claim After the

debtholders
DEBT EQUIITY
Maturity
Stated Permanent form
Tax treatment
Dividend are not

tax deductive
Common stock and Preferred stock
Common stock
The true owners of a corporate business are the common stockholders.
They can not lose any more than they have invested in the firm
Privately owned Publicly owned

• Private investors • Public investors
• Individual or a small group • Unrelated individual or
of investors institutional investors
• A small private firm • Large corporation
• Not publicly trading • Trading on the market
Common stock
Par value: The value of Preemptive rights: Allow

the common stock is an common stockholders to
arbitrary value maintain their
established for the legal proportionate ownership in
purposes in the firm’s the corporation when new
corporate charter shares are issued
Common stock
Authorized shares Treasury stock Outstanding shares

is the share of are repurchased is a part of the
common stock that by their firm. authorized shares
a firm’s corporate which are issued or
charter allows it to sold to the investors,
issue Issuing including both private
share and public investors
Common stock
Voting right: Each share of common

stock is one vote in the election of
directors and special issues.
They may sign a proxy statement
transferring their vote to another.
Common stock
Dividends
- Cash is the most common way
- Common stockholders are not promised a dividend
- Dividend must pay to the preferred stockholders
- Payment dividend can be affected by debt.
International stock issues

It helps the company to integrate to the local
business environment
Preferred stock
It gives the stockholders certain privileges and promises
a fixed percentage dividend.
Par-value preferred stock

No-par preferred stock
Preferred stock with a stated
Preferred stock with no
face value that is used with the
stated face value but with
specified dividend percentage
a stated annual dollar
to determine the annual dollar
dividend.
dividend.
Preferred stock
Features
Basic right
- Fix amount of dividend payments
• Considering quasi-debt
- along with the stock’s par value
• No maturity date
- Restrictive covenants
• Priority the liquidation
- All dividend must be paid before the
of assets
payment of common stock
• Normally nonvoting right
- Preferred stock can be callable
Issuing common stock
Public Offering
Rights Offering
in which it offers its
3 In which new shares
shares for sale to the
ways are sold to the existing
general public
stockholders
Private Placement
The firm sells the new securities
directly to an investor or group
of investors
Issuing common stock – Going Public
Initial Public Offering (IPO): Basic process
- The first public sale of a firm’s stock

- Must be approval of its current shareholders
- Bank willing to underwrite the offering
- A registration statement with the SEC (prospectus)
- Promote the company’s stock offering through a road
show: providing the information of offering.
- SEC approve the offering.
Common Stock Valuation - Market efficiency:
- Buyer, the asset’s value represent the maximum

purchase price
- Seller it shows the minimum share price.
- Market price reflects the collective actions on the
basis of all available information.
- The buyers and sellers approach the new
information quickly which create a new market
equilibrium price.
Common Stock Valuation
Securities are typically in equilibrium, their expected

return equal their required return
Efficiency -
the price of securities fully reflect all information
Market
Hypothesis available, the prices react swiftly to new information
stocks are fully and fairly priced, , investors need not

waste their time trying to find mispriced
(undervalued and overvalued) securities
Basic Common Stock Valuation Equation
- P0 = value today of common stock
- Dt = per-share dividend expected at the end of year t
- rs = required return on common stock
Three models here: zero growth, constant

growth, and variable growth.
Zero growth model
An approach to dividend valuation that assumes a

constant, non-growing dividend stream
D1 = D1 = … = D∞
Zero growth model
Scotto Manufacturing‘s most recent common stock dividend was
$2.40 per share. The firm’s management feels that dividends will
remain at the current level for the foreseeable future.
a. If the required return is 12%, what will be the value of Scotto’s
common stock?
b. If the required return to rise to 20%, what will be the common
stock value?
Zero growth model P0 = ?
D1 = $2.4
rs = 12% and 20%
𝐷1 $2.4
a. P0 = = = $20
𝑟𝑠 0.12
𝐷1 $2.4
b. P0 = = = $12
𝑟𝑠 0.2
Zero growth model:
Preferred stock valuation: a fix annual dividend is

typically provided to its holders. Equation of Zero – Growth
Model can be used to find the value of preferred stock
Constant – Growth model or Gordon growth model
- Dividends will grow at a constant rate (g)

- D0 represent the most recent dividend
0 1 2 3 Years
D0 D1 D2 D3
D1 = D0(1+g)1 D2 = D0(1+g)2 D3 = D0(1+g)3
1 2 ∞
𝐷0 𝑥 1 + 𝑔 𝐷0 𝑥 1 + 𝑔 𝐷0 𝑥 1 + 𝑔
𝑃0 = + + ⋯+
1 + 𝑟𝑠 1 1 + 𝑟2 2 1 + 𝑟𝑠 ∞
Constant – Growth model or Gordon growth model
1 2 ∞
𝐷0 𝑥 1 + 𝑔 𝐷0 𝑥 1 + 𝑔 𝐷0 𝑥 1 + 𝑔
𝑃0 = + + ⋯+
1 + 𝑟𝑠 1 1 + 𝑟2 2 1 + 𝑟𝑠 ∞
it can be written as
𝐷1
𝑃0 =
𝑟𝑠 − 𝑔
Constant – Growth model
Calculation the require return
𝐷1 𝑫𝟏
𝑃0 = 𝒓𝒔 = +𝒈
𝑟𝑠 − 𝑔 𝑷𝟎
𝒓𝒔 is require return of the market, we can use it to

calculate the stock on the market
Example: Calculate 𝑷𝟎
BA company ‘s most recent common stock dividend was

$2.00 per share. The company expects earnings and
dividends to grow at a rate of 5% per year for the
foreseeable future. The required return is 15%, what will
be the value of BA’s common stock?
Example: Calculate 𝒈
XYZ company’s next common stock dividend will be $5.00

per share. The present value of common stock is $50.00
per share at this time. The required return is 15%, what is
the growth rate of XYZ’s common stock?
Example: Calculate 𝒓𝒔
BA company ‘s most recent common stock dividend was

$2.00 per share. The company expects earnings and
dividends to grow at a rate of 5% per year for the
foreseeable future. The present value of BA’s common
stock is $20. What will be the market’s return?
ECT has paid the dividends shown in the following table
over the past 6 years.
The firm’s dividend per share next

year is expected to be $3.02. You can
earn 13% on similar-risk investments
what is the most you would be willing
to pay per share?
Variable – Growth model
For many firms (especially those in new or high-tech
industries), dividends are low but are expected to grow
rapidly. As product markets mature, the dividend growth
rate is then expected to slow to a “steady state” rate. How
should stocks such as these be valued?
P0 = PV of dividends in the non-constant growth period(s)
+ PV of dividends in the “steady state” period

Example:
Booboo Corporation just paid an common stock dividend
of 2$/year. From this year, dividend is expected to grow
at 10% for the next 3 years and then down to 8% forever.
What is the value of Booboo stock if required rate of
return for Booboo’s stock is 16%?

rs= 16%
g1= 10% g2= 8%
∞
D0 = 2.00 D1 D2 D3 D4
PV(D1)
PV(D2)
PV(D3)
PV(P3) P3
P0
rs= 16%
g1= 10% g2= 8%
∞
D0 = 2.00 2.2 2.42 2.662 2.875 2.875
1.897
1.798
1.705
23.023 35.937
P0 = 28.424
In general:
Step 1: Calculation of PV of each dividend of the initial
growth period;
Step 2: Calculation the present value of the stock’s price
at the end of the initial growth period;
Step 3: The sum of all present values above is the
common stock’s price.
Free cash flow valuation model
A model that determines the value of an entire company as the
present value of its expected free cash flows discounted at the
firm’s weighted average cost of capital, which is its expected
average future cost of funds over the long run.
Free cash flow model (FCFs) can be applied for:
- No dividend history
- Startups
- Division of a larger public company
Value of the entire company (Vc)
VC: Value of the entire company

VC = V S + V D + V P VD: The market value of all of the firm’s debt
VP: The market value of the preferred stock
VS: Common stock value
Common stock value (VS)

Common stock value, following the data below,
Step 1: Calculate the free cash flow occurring from the end of 2018
to infinity, using the constant-growth dividend valuation model
Step 2: Calculate the total value of FCF in 2017
Total FCF2017 = $600,000 + $10,300,000 = $10,900,000
Step 3: Find the sum of the present value of the FCFs

for 2013 through 2017 to show the value of the entire
company, VC
Step 4: Calculate the value of the common stock
VS = VC - VD – VP = $8,626,426 - $3,100,000 - $800,000
=> VS = $4,726,426
Common stock value = $4,726,426 : 300,000 = $15.76

Example 1
 Company A has 4 years old and experienced spectacular growth since
its inception. It is not expected for A to pay dividends for the next 5
years. You believe they will start paying in year six with $20 for the
dividend and $7 in year 7. After that you expect A to pay a constant
dividend of $8 per share the foreseeable future. If the discount rate is
10%. What is the current stock price?
Example 2
 An investor concerns about the risks coming from the Taiwan market,
so he decides to sell 20,000 shares of a Taiwanese enterprise. Knowing
that this business is listed on the Taiwan market at the price of 161.15 -
161.55, with a commission fees of 0.2% of the total transaction value.
In addition, the Taiwan stock market will impose a tax of 0.2% on the
transaction value of the seller. Assumed that the exchange rate between
USD / TWD is currently 28.41 – 28.53.
 Required: Calculte how much USD will be earned by this investor after
the trading transaction?
1. Mutual funds
• is an open-end investment company, the most familiar type of investment
company.
• Unlike closed-end funds and ETFs, mutual funds do not trade on stock exchanges.
Investors buy
mutual funds shares from investment companies, and sell their shares back to the
companies.
Benefits:
• The benefit of mutual fund is that it allows people with small money, not much
expertise in finance, to diversify their portfolios and get a higher normal return than
deposit institutions such as commercial banks.
• Participating in mutual funds will reduce transaction costs based on a sharing
mechanism
• Investing through a mutual fund will help amateur investors take advantage of the
expertise of fund managers, who are professionally trained in this field.
2. Closed-end funds
• Closed-end investment company
➢ is an investment company with a fixed capitalization whose shares trade on
exchanges and OTC
➢ offers investors an actively managed portfolio of securities
➢ To buy and sell, investors use their brokerage firms, paying (receiving) the
current price at which the shares are selling plus (less) brokerage commissions
• Shares of closed-end funds trade on stock exchanges, their prices are determined
by investors.
3. Individual and Institutional investors
• Institutional investors have a dual relationship with individual investors. On the
one hand, individuals are the indirect beneficiaries of institutional investor actions,
because they own or benefit from these institutions’ portfolios. On a daily basis,
however, they are “competing” with these institutions in the sense that both are
managing portfolios of securities and attempting do well financially by buying and
selling securities.
• Institutional investors are indeed the “professional” investors, with vast resources
at their command. In the past, they were often treated differently from individual
investors, because companies often disclosed important information selectively to
some institutional investors.
4. The Net Asset Value (NAV) is the per share value of the securities in the fund’s
portfolio (Topic 2)
• The Net Asset Value (NAV) is the per share value of the securities in the fund’s
portfolio.
• It is computed daily after the markets close at 4 p.m. by calculating the total market
value of the securities in the portfolio, subtracting any liabilities, and dividing by
the number of investment company fund shares currently outstanding.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑓𝑢𝑛𝑑′ 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠−𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
NAV =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
5. Margin Trading
➢Uses borrowed funds to purchase securities
➢Currently owned securities used as collateral for
margin loan from broker
➢Margin requirements set by Federal Reserve Board
✓Determines the minimum amount of equity
required
✓Initial margin is the percentage (50%) of fund acquired from investor; the balance
is borrowed
from broker. It is set by Federal Reserve System.
➢Can be used for common stocks, preferred stocks, bonds, mutual funds, options,
warrants and futures
• Advantages
➢ Allows use of financial leverage
➢ Magnifies profits
• Disadvantages
➢ Magnifies losses
➢ Interest expense on margin loan
➢ Margin calls
6. CAPM model
7. Bond valuation
8. Pricing stock (with dividends paid infinity/with constant growth or variable growth)
9. International bond market
10. International stock market

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1. To understand the investments field as currently practiced

• Suppose must invest this money intelligently in you are

• The term investing can cover a wide range of

• Most individuals make investment decisions

• Underlying investment decisions: the tradeoff

• Financial assets: real assets are tangible, physical

• Investors manage risk at a

• Uncertainty in ex post returns dominates decision process

• Institutional investors have a dual relationship with

1. Investors should always seek to maximize their

INDIRECT INVESTING &

1. Appreciate the importance of indirect investing to

• Closed-end investment company

• Generally an index fund priced and traded on

• is an open-end investment company, the most

• A mutual fund that invests in money market

• Assume the Titan Fund has a portfolio of stocks valued on

• Initial Public Offering (IPO) Common stock shares

• Secondary Market: the market in which securities are

• Broker Markets: consists of national and regional

• New York Stock Exchange (NYSE)

• Regional Stock Exchanges

• No centralized trading floor; comprised of market

• Indirect Ways to Invest in Foreign Securities

• Usual Investment Risks Still Apply

• Regular Trading Session for U.S. Exchanges

• Securities Act of 1933

• Investment Advisors Act of 1940

• Maintenance margin is the minimum amount of

• Basic Margin Formula

Value of securities - Debit balance

• Return on Invested Capital

Total Total Market Market

• Example of Return on Invested Capital

Risk & Rates of Return

Suppose the real rate is 3%, and the

The pattern of rates of return for debt

The pattern of rates of return for debt

time to maturity (years)

time to maturity (years)

The yield curve may be downward sloping or

time to maturity (years)

The yield curve may be downward sloping or

time to maturity (years)

For a Treasury security, what is

For a Treasury security, what is

Since Treasuries are essentially free of default

Required Risk-free Risk

How large of a risk premium should we require

Expected Return - the return that an

Required Return - the return that an

The expected return is a tool used to determine

For example, assume two hypothetical

Probability T-Bill Probability ElCat Corp

Probability T-Bill Probability ElCat Corp

State of Economy Probability Return

State of Economy Probability Return

Can compare the s of 7.57 to another s2 = 57.25%2

Number of stocks in Portfolio

Number of stocks in Portfolio

Jan 1992 -5%

Required Minimum rate of return necessary to