Comm221 Huyen

COMM 221: Financial Markets COMM 221: Financial Markets COMM 221: Financial Markets
Chapter 1: Time Value of Money Effective Interest Rates Annuities and Perpetuities
• The annual percentage rate (APR) is the interest rate that does not consider the effects • Recurring cash flows at equal intervals of time.
of compounding. This is also called the nominal rate or the quoted rate. • Can be infinite (perpetuities) or finite (annuities).
The Present Value • The present value of the cash flows is the sum of the present value of each payment.
• The value today of some amount in the future (the future value). • The effective rate is the APR adjusted for compounding and is the true discount rate
• Annuities can be calculated using your financial calculator.
• Found by discounting, this means to remove the interest. that should be used in TVM calculations.
• Perpetuities must be calculated using a formula.
• The interest rate used is called the discount rate. • The effective rate should always match the frequency of the payments (f). • Payments can be made at the beginning of the period (due) or at the end of the period
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• Used to evaluate the actual value of future cash flows and investments. (ordinary).
𝐴𝑃𝑅 %
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𝐹𝑉 Effective annual rate 𝐸𝐴𝑅 = 𝑘"!!#"$ = -1 + / −1 Present Value of an Ordinary Perpetuity
𝑃𝑉 = 𝑚
(1 + 𝑘)! %
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𝐴𝑃𝑅 - 𝑃𝑀𝑇
Effective periodic rate 𝑘&'()*+), = -1 + / −1 𝑃𝑉 =
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𝑚 𝑘
Exercise 1 Effective annual rate (continuous) 𝐸𝐴𝑅 = 𝑘"!!#"$ = 𝑒 ./0 − 1

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An investment has promised to pay you $1,000 in one year and $2,300 in three years. What is Present Value of a Perpetuity-due
-!
the value of the investment today if the discount rate is 9%? Effective-to-Effective 𝑘1 = (1 + 𝑘2 )-" − 1
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𝑃𝑀𝑇
𝑃𝑉 = (1 + 𝑘)
𝑘
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Exercise 3
Your account earns 8% interest compounded semi-annually and your bank has offered you a
Exercise 6
new savings account that they say is equivalent. This new account has quarterly compounding.
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An investment will return $500 per year for 10 years.
What is the interest rate quoted on the new account?
a) Calculate the present value using a discount rate of 8% APR compounded monthly.
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b) What if the first payment is received today?
Exercise 2
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You just invested $5,000 into an account earning 12% per year compounded monthly. How
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much will you have in your account in 4 years?
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Exercise 4
Exercise 7
What is the effective quarterly rate of 10% APR compounded semi-annually?
An investment will return $500 per year forever
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a) Calculate the present value using a discount rate of 8% APR compounded monthly.
b) What if the first payment is received today?
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Exercise 5
What is the effective annual rate of 14% compounded continuously?
© Copyright – 2024 – John Karras – All Rights Reserved. 4 © Copyright – 2024 – John Karras – All Rights Reserved. 5 © Copyright – 2024 – John Karras – All Rights Reserved. 6
Growing Annuities and Perpetuities Net Present Value Exercise 9

• Annuities or perpetuities with a constant growth rate (g). • Used to evaluate investments. ABC Shipping is considering investing in new self-driving 18 wheelers. Tesla has just
• Each payment increases (or decreases) by the constant rate. • Represents the profit earned. announced that they will begin delivering these vehicles in two years but required anyone
• Found by combining the present value of all cash inflows and outflows. interest in purchasing them to pay a 50% deposit today. The cost of each truck is $600,000 and
Present Value of a Growing Annuity ABC Shipping is ordering 10 of them. The balance of the payment is to be paid upon delivery
of the truck’s from Tesla. The company expects that these trucks will be put in use right away
𝑃𝑀𝑇 1+𝑔 ! 𝑁𝑃𝑉 = 𝑃𝑉(𝑖𝑛𝑓𝑙𝑜𝑤𝑠) − 𝑃𝑉(𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠) and will begin generating $30,000 in profit each per month. ABC Shipping has a cost of capital
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𝑃𝑉 = 51 − - / 6 of 10% per year.
𝑘−𝑔 1+𝑘
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A) What is the value of this capital expenditure?
Present Value of a Growing Perpetuity Exercise 8
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You are considering purchasing a new truck for your business. The truck will cost $124,000 up
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𝑃𝑉 = front but will generate additional sales of $45,000 per year for 7 years. You expect to sell the
𝑘−𝑔 truck for $30,000 at the end of the fifth year. Your cost of capital is 13%. Should you buy the
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B) Should ABC Shipping buy the trucks?
truck?
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Exercise 6
A stock will pay you a $2 dividend next year and 5% more each year forever. The discount rate
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is 8%, what is the value of the stock?
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Exercise 7
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You will receive $600 next year, and then 8% more each year for a total of 10 years. The
discount rate is 7% per year, what is the present value of this cash flow?
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Depletable Projects Chapter 2: Personal Finance Calculating Income Tax

• Projects that are depleted as they are used to generate cash flows. • Income tax is based on taxable income and federal/provincial marginal tax rates.
• Sustainable projects: projects that can be sustained as long as they are not exhausted. Tax Planning Strategies • Marginal tax rate is the tax rate charged on the next dollar earned.
• Non-renewable: cannot be used again. Tax planning ensures financial plans are executed in a tax-efficient manner. Key strategies • Only 50% of capital gains are added to taxable income.
• Depletable projects are valued at their present value using a negative growth rate. include:
• Tax-Advantaged Accounts: Utilizing accounts like RRSPs and TFSAs to attain notable
tax benefits, with RRSP contributions being tax-deductible and TFSA allowing tax-free
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Exercise 8 growth and withdrawals.
An oil field will generate $5M in profit this year, but this amount is expected to decrease at a
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rate of 6% per year indefinitely. What is the value of this project if the appropriate discount • Income Splitting: Mitigating overall family tax liability by redistributing income from
rate is 8%? higher to lower-income family members through mechanisms like spousal RRSP
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contributions or investment loans.
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• Investing in Eligible Dividends: Leveraging tax credits associated with eligible
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dividends from Canadian corporations to minimize tax on this income type.
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• Capital Gains Planning: Strategically managing investments to exploit the 50% tax
applicability on capital gains, favouring investments that appreciate over time and
𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 𝑃𝑎𝑦𝑎𝑏𝑙𝑒
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utilizing preferential long-term capital gains tax rates. 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 =
𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒
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Additional Tax Planning Strategies: Exercise 1
• Tax-loss Harvesting What is the average tax rate and the marginal tax rate for someone who earns $125,000?
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o Offsetting capital gains tax liability through intentionally selling securities at a
loss, particularly valuable during financial downturns, enabling the cushioning of
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investment losses against taxable gains.
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TAX-FREE SAVINGS ACCOUNT (TFSA) Registered Retirement Savings Plan (RRSP) Hedge Funds
• Like mutual funds but only for accredited investors.
• Annual contributions can be made up to the set limit. • Savings account meant to save for retirement. o Accredited investors have large wealth (at least $2M)
• Contributions are not tax deductible. • Annual contributions are based on earned income in previous years. • Will take more risk than traditional mutual funds by using debt and holding derivative
• Contributions carry over starting the year you turn 18 years old. • Unused contributions carry over. securities.
• Withdrawals are added to contribution room on January 1st of the following year. • Contributions are tax-deductible. • Typically have high fees.
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• All investment income/profits are completely tax free. o This means they are deducted from your income and lower your tax for the year. o Management fees: a percentage of the assets under management.
• Withdrawals are added to income and taxed. o Incentive fees: a percentage of any return above a defined threshold.
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Exercise 1 • Contributions can be made until December 31 of the year you turn 71.
Today is December 31st, 2023. Steve turned 24 years old on August 23rd 2023 and has o RRSP must be closed or converted to a different account by the same date.
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Real Estate Investment Trusts (REITs)
contributed the maximum to his RRSP each year on January 1st. He has consistently earned 9% • Like mutual funds but for real estate.
per year. How much does he currently have saved up in his TFSA?
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Investments • Investor buys shares of the fund, the fund owns real estate.
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Certificates of Deposit (CDs)
• Time deposits offered by banks with a fixed term.
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• Money is locked in for the term and you earn interest on it. The Sharpe Ratio
• Higher returns than savings accounts since money is locked in. • Measures the performance of an investment or fund by comparing it to the
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performance of the market.
Commercial Paper • Based on return on investment, risk free rate and standard deviation (risk) of the
• Short-term unsecured loan that has no collateral.
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investment.
• Typically sold at a discount to face value.
• Returns should be reduced by the fees before calculating the sharpe ratio.
• The discount rate is the implied rate of return.
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𝑅) − 𝑅𝑓
𝑆𝑅) =
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Mutual Funds 𝜎)
• Diversified portfolios that you can buy shares of.
Exercise 3
• By owning shares of the fund, you own a bit of every asset within the fund.
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A Hedge fund has a management fee of 6% on their assets under management and the
• Funds are professionally managed and allow investors to diversify without needing large
incentive fee is 40% for any return above 30%. If the average 5-year annual return for this
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sums of capital.
hedge fund is 42% and the standard deviation of these returns is 19%, what is your estimate of
o Mutual funds usually charge a management fee.
Sharpe Ratio? Assume an annual risk free rate of 5%.
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Exchange-Traded Funds (ETFs)
• Like mutual funds, but traded on stock exchanges like stocks.
• Typically have lower fees than mutual funds.
Instalment Loans Chapter 3: Bond and Equity Valuation Exercise 1

• Loans that are repaid in equal periodic instalments. A bond with a $1,000 face value and an 8% coupon rate was just issued. The bond has 9 year
• Typically have blended payments with a principal and an interest portion. What are Bonds remaining until maturity and is yielding 12%. The coupons are paid semi-annually. What is the
• Examples: car loans, mortgages • Fixed income investments that promise the investor periodic interest payments value of this bond?
(coupons) and a lump sum payment upon maturity (face value).
Exercise 4 • The market value of a bond (price) is the present value of the coupons and of the face
You just borrowed $750,000 from the bank to buy a new condo. The mortgage has a term of 5 value.
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years and a 30-year amortization period. The interest rate is 5.5% APR compounded semi- • The return earned on a bond investment that is held until maturity is called the yield to
annually. maturity.
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o This is used as our discount rate to value the bonds.
a) What is your monthly mortgage payment?
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Coupon Rate vs Yield
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Exercise 2
• CR = YTM: the bond is sold at ‘par’, meaning the Price = Face Value. Which of the following bonds would sustain the largest price drop if the Bank of Canada raises
• CR > YTM: the bond is sold at a ‘premium’, meaning the Price > Face Value. the interest rate by 1%?
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• CR < YTM: the bond is sold at a ‘discount’, meaning the Price < Face Value. a) 10-year, 5% coupon bond
b) 10-year, 2% coupon bond
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Interest Rate Risk c) 4-year, 6% coupon bond
• Bond prices are inversely related to market interest rates. d) 4-year, 2% coupon bond
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• Bonds with longer maturities and lower coupon rates are more sensitive to changes
in the interest rate.
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The price-yield curve
b) How much will you owe on your mortgage at the end of the term?
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Exercise 3
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A bond is currently trading for $875.44, it has a coupon rate of 7% paid semi-annually and 10
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years remaining until maturity. What is the YTM on this bond?
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What are Stocks Exercise 3 Chapter 4: Risk, Return and Portfolio Theory
• Equity investments that represent ownership in a company. ABC Inc’s stock just paid a dividend of $2.20 per share. Investors expect these dividends will
remain constant forever. The required rate of return on these shares is 9%. What is the value of
• Stocks pay the investor dividends, which represent their share of the company’s profits. Measuring Returns
the stock?
• Dividend discount model: The price of the stock is the present value of future • Ex-post returns: Past or historical returns
expected dividends. • Ex-ante returns: Future or expected returns
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Price of a Stock with Constant Growth Average Returns
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𝐷1
𝑃3 = The average return can be measures in two ways:
𝑘−𝑔 1. Arithmetic mean: the numerical average of the returns.
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Exercise 4
ABC Inc’s stock just paid a dividend of $2.20 per share. Investors expect these dividends grow 2. Geometric mean: the average return taking into account the compounding effects.
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by 7% per year. The required rate of return on these shares is 11%. What is the value of the
Price of a Stock with No-Growth stock? 1
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𝐺𝑀 = [(1 + 𝑟1 )(1 + 𝑟2 )(1 + 𝑟4 ) + ⋯ (1 + 𝑟! )]! − 1
𝐷
𝑃3 =
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𝑘 Exercise 1
Estimate the arithmetic mean (AM) and geometric mean (GM) for the following returns: 5.4%,
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6.2%, 4.5%, -7.8%, 10.1%.
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Expected Returns 8.2 Measuring Risk Exercise 3

Estimated future annual return based on probabilities. Suppose you are given the following information for two stocks, A and B, where the return on
Standard Deviation each varies with the state of the economy.
A measure of total risk over all the observations. State of the Probability Expected Return on Expected Return on
𝐸𝑅) = Σ(𝑟) × 𝑝𝑟𝑜𝑏) Economy Stock A in this state Stock B in this state
High Growth 0.70 50% 10%
Recession 0.30 -10% 20%
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Exercise 2 Σ(𝑟 − 𝑟̅ )2 Expected Return ? 13%
Suppose you are given the following information for two stocks, A and B, where the return on
𝐸𝑥 − 𝑝𝑜𝑠𝑡 𝜎 = T
𝑛−1
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each varies with the state of the economy. Calculate the standard deviation for Stock A.
State of the Probability Expected Return on Expected Return on
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Economy Stock A in this state Stock B in this state
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High Growth 0.70 50% 10% 𝐸𝑥 − 𝑎𝑛𝑡𝑒 𝜎 = VΣ(𝑝𝑟𝑜𝑏(𝑟) − 𝐸𝑅) )2
Recession 0.30 -10% 20%
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Expected Return ? 13%
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Calculate the expected return for Stock A Limitations of the standard deviation
• Symmetry: Standard deviation treats outcomes above and below the mean equally,
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neglecting the true importance of each outcome in assessing risk.
• Stationarity: It relies on historical data, assuming past trends will continue, which may
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not always be the case.
Exercise 4
• Discrete distributions: Standard deviation may not accurately represent risk in cases of You have observed the following annual returns for Motherboard Inc.: 25%, 15%, -20%, 30%,
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small samples or non-normal distributions, especially where outcomes are highly and -15%. What are the variance and standard deviation of returns?
discrete, like complete loss or doubling of investment.
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Portfolio Theory Covariance

• A statistical measure that compares the movement of two different stocks. Portfolio Standard Deviation
Expected Return and Risk of a Portfolio • A positive covariance indicates that the stocks have a tendency to move in the same
• A portfolio is a collection of investments combined to form a single asset. direction. • Using the covariance, we can compute the standard deviation of the entire portfolio.
• Could be made up of different kinds of investments like bonds, stocks, crypto, etc. • A negative covariance indicates that the stocks have a tendency to move in opposite • The portfolio standard deviation is not the weighted average of the standard deviation
directions. of the stocks within the portfolio, unless the stocks have a perfect positive
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• The covariance only measures the direction, not the strength, of the relationship correlation.
Portfolio Expected Return between two stocks.

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• The weighted average return of the assets within the portfolio.
𝜎& = [𝑤.2 𝜎.2 + 𝑤52 𝜎52 + 2𝑤. 𝑤5 𝐶𝑂𝑉.5
• Weights are based on the dollars invested in each asset.
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𝐶𝑂𝑉.5 = 𝜌.5 𝜎. 𝜎5 = Z 𝑝𝑟𝑜𝑏(𝑟. − 𝐸𝑅. )(𝑟5 − 𝐸𝑅5 )
𝐸𝑅& = Σ(𝑤) × 𝐸𝑅) )

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Exercise 7
Exercise 6 Suppose you are given the following information for two stocks, A and B, where the return on
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Exercise 5 Suppose you are given the following information for two stocks, A and B, where the return on each varies with the state of the economy.
Suppose you are given the following information for two stocks, A and B, where the return on each varies with the state of the economy. State of the Probability Expected Return on Expected Return on
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each varies with the state of the economy. State of the Probability Expected Return on Expected Return on Economy Stock A in this state Stock B in this state
State of the Probability Expected Return on Expected Return on Economy Stock A in this state Stock B in this state High Growth 0.70 50% 10%
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Economy Stock A in this state Stock B in this state High Growth 0.70 50% 10% Recession 0.30 -10% 20%
High Growth 0.70 50% 10% Recession 0.30 -10% 20% Expected Return ? 13%
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Recession 0.30 -10% 20% Expected Return ? 13%
Expected Return ? 13% What is the standard deviation of a portfolio that has 25% invested in Stock A and 75%
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What is the covariance between stocks A and B? invested in stock B, assume the standard deviation of Stock B is 5.76%.
Estimate the expected return for a portfolio that has $500 invested in stock A and $1,500
invested in Stock B.
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Correlation Coefficient Perfect Correlations Systematic and Unsystematic Risk

• A statistical measure of strength and direction of the relationship between two stocks.
Investments are said to be perfectly correlated (positive or negative) if the correlation Systematic Risk
• A positive correlation means the stocks tend to move in the same direction.
coefficient is equal to 1 or -1.
• A negative correlation means the stocks tend to move in opposite directions. • Risk that affects the entire market.
• A correlation closer to -1 or +1 is stronger. • Investing in stocks with a perfect positive correlation provides absolutely no • Also called market risk.
• A correlation closer to 0 is weaker. diversification. • Unavoidable.
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• The closer the correlation coefficient is to -1, the more diversification there is. • Symbol: beta (𝛽)
𝐶𝑂𝑉.5
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𝜌.5 = 𝜎& = 𝑤. 𝜎. + 𝑤5 𝜎5
𝜎. 𝜎5 Unsystematic Risk
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• Asset or industry specific risk
Only if 𝜌.5 = +1
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• Also called: specific risk, diversifiable risk, idiosyncratic risk
Exercise 8 • Avoidable through diversification
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A portfolio consists of two securities: Nervy and Goofy. The expected return of Nervy is 12 𝜎& < 𝑤. 𝜎. + 𝑤5 𝜎5
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percent with a standard deviation of 15 percent. The expected return of Goofy is 9 percent with
a standard deviation of 10 percent. What is the portfolio standard deviation if 35% of the
𝜌.5 < +1
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portfolio is invested in Nervy and the two securities have a correlation of 0.6?
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CAPM and The Security Market Line Exercise 9 Multifactor Models

• Relationship between return and market risk (beta). The market’s expected return and standard deviation are 20% and 15% respectively. Stock Y is • Like CAPM but with more than one slope (risk factor).
currently trading for $24, it just paid a dividend of $2 per share and investors expect the • Based on multiple regressions.
• Slope of the line is called the market risk premium and is determined by the market’s dividends to grow by 4% per year forever. The stock’s beta is 1.5. T-bills are yielding 3.5%. • Three common models:
expected return and the risk free rate. a) What is the required rate of return on the stock? o Fama-French (3 factors)
b) If the stock correctly priced? o Carhart (4 factors)
• CAPM Assumption: That the entire return earned on a stock is due to the systematic risk
o Fama-French (5 factors)
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(market risk). Since unsystematic risk can be virtually eliminated through diversification, the
expected return on unsystematic risk is zero. Fama-French Three-Factor Model
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• The return earned for every 1 unit of market risk (beta) is called the Treynor Ratio. 𝑅) = 𝑅𝑓 + 𝛽1 (𝑅% − 𝑅𝑓) + 𝛽2 (𝑆𝑀𝐿) + 𝛽4 (𝐻𝑀𝐿)
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Carhart Four-Factor Model
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𝑅) = 𝑅𝑓 + 𝛽1 (𝑅% − 𝑅𝑓) + 𝛽2 (𝑆𝑀𝐿) + 𝛽4 (𝑃𝑅1𝑌𝑅)
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Fama-French Five-Factor Model
𝑅) = 𝑅𝑓 + 𝛽1 (𝑅% − 𝑅𝑓) + 𝛽2 (𝑆𝑀𝐿) + 𝛽4 (𝐻𝑀𝐿) + 𝛽6 (𝑅𝑀𝑊) + 𝛽7 (𝐶𝑀𝐴)

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Exercise 10
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You’re interested in determine the true expected return on share of Dominos Pizza (DPZ) using
the Fama-French three factor model. You estimate the betas at 𝛽! = 1.4, 𝛽" = 0.99, 𝛽# = 1.4.
𝑘) = 𝑅𝐹 + (𝐸𝑅% − 𝑅𝐹)𝛽) You also estimate the risk premia to be SML = 1.5%, HML = 4%. T-bills are currently yielding
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5.5% and the market is expected return 14% this year.
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Preference Towards Risk Exercise 11 Chapter 5: Supply and Demand

Let’s assume your utility function is:
𝑈(𝑊) = 𝑊 $.&
Risk Averse
• Dislikes risk, will choose a certain outcome over a risky outcome if they have the same Supply
Your only source of wealth is your house valued at $500,000. You know that there is a 5%
expected value.
chance that your home is damaged by floods and are considering buying insurance. If your
• Willing to pay to eliminate risk (insurance). • Tells us the quantity suppliers are willing to supply at each price.
home is damaged, you will need to spend $150,000 repairing it. How much are you willing to
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• Decreasing marginal utility of income. • Upward sloping because supplier will want to supply more at higher prices.
pay for the insurance?
• Will only choose a risky outcome if the expected value is sufficiently larger than the
certain income.
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o We measure this using the expected utility (EUT) and certainty equivalent 𝑃8 = 𝑐 + 𝑑𝑄 𝑄8 = 𝑐 + 𝑑𝑃
(CEQ).
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o This is the certain income that yields the same utility as the risky one.
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Demand
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Risk Neutral
• Indifferent towards risk. Will always choose the outcome with the greater expected • Tells us the quantity buyers are willing to purchase at each price.
• Downward sloping because buyers will want to buy less at higher prices.
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value.
• Will be indifferent between a risky investment and certain income if they have the same
expected value. 𝑃+ = 𝑎 − 𝑏𝑄 𝑄+ = 𝑎 − 𝑏𝑃
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Risk Loving
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• Likes risk, will choose a risky outcome over a certain one if they have the same expected
value. Equilibrium
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• Point where supply equals demand.
• Markets will always move towards an equilibrium if they are not interfered with, this is
called the market mechanism.
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Economic Surplus Exercise 1 Government Interventions/Distortions
Consumer Surplus In the market for widgets, the supply and demand prices are:
• The difference between what a consumer pays, and the maximum they would have paid. Price Cap/Maximum Price
• How to find graphically: 𝑃+ = 200 − 0.2𝑄 • Only effective if set below the free-market equilibrium price.
o Below demand; 𝑃8 = 20 + 0.3𝑄 • Reduces the price and quantity.
o Above price consumers pay; • Always reduces producer surplus, can increase or decrease consumer surplus.
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o Left of quantity consumers purchase. Where Q is the quantity of widgets.
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Producer Surplus
• The difference between what a suppliers receive pays and the minimum they would a) What is the equilibrium price and quantity?
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have accepted. b) What are the total gains from trade?
• How to find graphically:
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o Above supply;
o Below price suppliers receive;
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o Left of quantity suppliers sell.
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Price Floor/Minimum Price
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• Only effective if set above the free-market equilibrium price.
• Increases the price and reduces the quantity.
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• Always reduces consumer surplus, can increase or decrease producer surplus.
• Minimum wages are a type of price floor in the labour market.
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Economic Surplus/Total Gains from Trade
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• Sum of consumer and producer surplus.
Deadweight Loss
• The loss in total economic benefit as a result of a government intervention/distortion.
Production Quota
Exercise 2
• Limit on the amount of units suppliers can produce. In the market for widgets, the supply and demand prices are:
• Reduces quantity and increases price.
• Always reduces consumer surplus, can increase or decrease producer surplus. 𝑃+ = 200 − 0.2𝑄
• Same effect as price floor.
𝑃8 = 20 + 0.3𝑄
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Where Q is the quantity of widgets. The government is considering imposing a
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$100 price cap on widgets.
a) What is the consumer surplus after the price cap?
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b) What is the producer surplus after the price cap?
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c) What is the deadweight loss?
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Excise Tax/Fixed Price Tax
• Tax on every unit sold. Reduces quantity.
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• Increase price consumers pay and decreases price suppliers receive.
• Reduces both consumer and producer surplus, but increases government revenue.
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o The more inelastic supply and demand are, the more they will lose in surplus.
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Exercise 3 Exercise 4 Exercise 5

In the market for widgets, the supply and demand prices are: In the market for widgets, the supply and demand prices are: In the market for widgets, the supply and demand prices are:
𝑃+ = 200 − 0.2𝑄 𝑃+ = 200 − 0.2𝑄 𝑃+ = 200 − 0.2𝑄

𝑃8 = 20 + 0.3𝑄 𝑃8 = 20 + 0.3𝑄 𝑃8 = 20 + 0.3𝑄
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Where Q is the quantity of widgets. The government is considering imposing a Where Q is the quantity of widgets. The government is considering imposing a Where Q is the quantity of widgets. The government is considering imposing a
$140 price floor on widgets. output quota of 200 units. tax of $10 per unit on widgets.
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a) What is the consumer surplus after the price floor? a) What is the consumer surplus after the output quota? a) What is the consumer surplus after the tax?
b) What is the producer surplus after the price floor? b) What is the producer surplus after the output quota? b) What is the producer surplus after the tax?
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c) What is the deadweight loss? c) What is the deadweight loss? c) What is the government revenue?
d) What is the deadweight loss?
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Elasticity Efficiencies Chapter 6: Historical Events

Operational Efficiency
• Price elasticity measures how sensitive quantity demanded and supplied are to changes The effectiveness and productivity of a business or market in producing goods or
• Tulip Mania (1630)
in price. services.
• It is the ratio of the percentage change in quantity to the percentage change in price.
• It essentially measures how well resources (such as time, labor, and capital) are utilized • Tulip Mania of 1630s in Holland: Early economic bubble phenomenon.
• Consumers will be more elastic with luxuries and more inelastic with necessities.
to achieve desired outcomes. o A bubble is an economic phenomenon characterized by a rapid and
• The more inelastic the demand, the steeper the demand curve and the greater the
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unsustainable increase in the price of an asset, often followed by a sharp and
consumer surplus. • Examples of Inefficiencies: significant decline.
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o Manual data entry processes leading to errors and delays.
o Overproduction resulting in excess inventory and storage costs. o Irrational exuberance: a state of excessive optimism and enthusiasm in financial
%Δ𝑄 markets that is not supported by underlying fundamentals or rational analysis,
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𝜂= o Inefficient use of machinery or equipment causing downtime and maintenance
%Δ𝑃 leading to overinflation of asset prices.
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expenses.
o Excessive regulations that hinder productivity. • Tulip bulb prices surpassed Amsterdam town home prices.
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Inelastic 𝜂<1 %𝛥𝑄 < %𝛥𝑃 Informational Efficiency: • Lack of legal mechanisms for futures contracts enforcement exacerbated collapse.
Elastic 𝜂>1 %𝛥𝑄 > %𝛥𝑃 • Informational efficiency refers to the ability of markets to reflect all publicly available
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• Many contracts went unfulfilled or settled for a fraction of their value.
Unit Elastic 𝜂=1 %𝛥𝑄 = %𝛥𝑃 information in asset prices.
• Examples of inefficiencies: • Long-term scarcity of tulip bulbs questioned due to self-replication.
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o Insider trading, where individuals trade securities based on non-public • Limited data available, but event highlighted detachment of market prices from
information, leading to distortions in asset prices.
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Exercise 6 functional utility.
In the market for widgets, the quantity demanded increases from 10,000 to 11,000 when price o Market manipulation, such as pump-and-dump schemes, artificially inflating or
deflating prices by spreading false information. • Greed and fear identified as key drivers of market behavior during the bubble.
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decreases from $3 to $2.40. What is the price elasticity of demand?
o Information asymmetry, where one party has access to information that others do
not, leading to unfair advantages and market inefficiencies.
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Allocative Efficiency:
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• Allocational efficiency concerns the optimal allocation of resources in an economy to
maximize overall welfare or utility.
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• Informational and operational efficiency leads to allocative efficiency.
• Examples of inefficiencies:
o Firm’s reducing output of a product to sell it at a higher price.
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o Underutilization of resources.
o Negative externalities like pollution, traffic.
Black Wallstreet & Tulsa Riots (1921) The 1929 Crash The 1987 Crash
• In 1921, Tulsa, Oklahoma was home to Greenwood, a thriving community of over 10,000 • 1929 Stock Crash: Notable market meltdown characterized by an 11% decline on Black
• 1987 Stock Market Crash: Notable for similarities to 1929 crash, exacerbated by
Black residents in the Northeast part of the city. Thursday (Oct 24) and a further 12.5% drop on Black Monday (Oct 28).
computerized trading.
• Capital Market Creation: Segregation laws forced Greenwood residents to rely on their • Severe compared to past slides like the 1907 panic due to large individual investors
o Computerized trading, also known as high-frequency trading and algorithmic
own businesses for essential goods and services, leading to the development of failing to calm the public.
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trading, involves the use of automated computer programs, or algorithms, to
Blackwall Street, a hub of trade and commerce.
• Heavy margin use exacerbated the crash, as small investors bought stocks with partial analyze market data and execute buy or sell orders in financial markets without
Despite facing racial tensions, Greenwood flourished with amenities including medical down-payments financed by broker loans, driving demand. human intervention.
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•
services, legal counsel, and various retail stores, with capital mainly coming from the o Margin: Margin refers to the practice of buying stocks with borrowed money,
• DJIA saw rapid rise from 776 in August 1982 to peak of 2722 in August 1987, a 250%
Black community itself. using only a partial down-payment, with the remaining funds provided by a
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increase in 5 years.
broker.
• Tragedy struck in 1921 when a false accusation of assault incited white citizens to
• Margin trading and high debt levels reminiscent of 1929 crash.
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violence, resulting in a devastating riot that destroyed over 1000 homes and claimed • Declining stock prices triggered margin calls, where brokers demanded additional
possibly 300 lives. capital, leading to further selling and price drops. • Black Monday on October 19, 1987, witnessed a 22.6% drop in DJIA, triggered by
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automated trading and loss limit orders.
• Despite efforts to rebuild, vindictive rezoning and lack of support hindered Greenwood's • Painful lessons from the 1920s led to the establishment of regulations and institutions
recovery, compounded by desegregation in the 1950s and 1960s which further to monitor investor debt loads. • Automated selling exacerbated decline, creating a downward cascade beyond human
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diminished its economic viability. ability to respond.
• Removal of old regulations could potentially lead to predictable subsequent bubbles
• and crashes. • Resulted in implementation of limits on computer trading and electronic circuit breakers
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While Greenwood never fully regained its economic significance, the community's
resilience is evident in the rapid rebuilding efforts, though the lasting economic damage in global markets to halt trading temporarily for human assessment.
highlights the impact of fear and loss of human capital on a once-thriving marketplace.
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Acid Rain Program and Sulfur Dioxide Allowances The Dot-Com Bubble (2000) The MBS Crisis (2008)
Acid Rain Crisis • Approach to Millennium: Companies rushed to establish online presence as computers • Mortgage Backed Security Crisis: Rooted in 1970s innovation, exacerbated by 1980s
• Sulfur dioxide (SO2) and nitrogen oxide emissions caused acid rain, damaging forests, became commonplace in homes. deregulation, demographic shifts, and shortage of high-yielding investments.
water sources, and agriculture. • Dot-com Bubble: Speculative interest in Dot-com companies led to a surge in stock o Mortgage Backed Securities (MBS): Investment vehicle created by pooling
• Traditional regulatory approaches proved inadequate to address this widespread prices. mortgages into portfolios, allowing cash flows to be re-prioritized to different
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environmental threat. tranches.
• Derivative Securities: contracts between parties whose value is derived from the
performance of an underlying asset, index, or entity, used for risk management, Credit Default Swaps: financial derivatives that allow investors to hedge against the
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Acid Rain Program •
• Initiated by the United States EPA in 1990 under the Clean Air Act Amendments. speculation, or investment purposes. risk of default on debt instruments or speculate on creditworthiness by transferring
o Played a role in the dot-com bubble by facilitating excessive speculation. credit risk to another party in exchange for periodic payments.
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o Clean Air Act Amendments: Legislation aimed at reducing air pollution through
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comprehensive reforms, possibly including market-based mechanisms. • Tech-heavy indices like Nasdaq experienced dramatic rises. o Credit default swaps worsened the 2008 financial crisis by encouraging risky
• Utilizes emissions trading mechanism, focusing on coal-burning power plants, granting lending and providing false security, leading to widespread losses when the
• Online infrastructure unprepared: Web and logistics struggled to handle rush to online
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allowances for SO2 emissions. housing bubble burst and mortgage defaults surged, exacerbated by lack of
services, leading to fractured services and expensive delivery.
• Implemented in phases, with Phase I targeting a 50% reduction by 1995 and Phase II regulation and transparency.
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further tightening restrictions by 2000. • Corporate casualties: Bankruptcies of companies like Webvan and Petfood.com, unable
• Flood of Money: High-income baby boomer generation approaching retirement
• SO2 emissions significantly decreased, meeting long-term goals ahead of schedule, to meet investor expectations.
contributed to increased investment in housing market.
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fostering innovation and cost-effective solutions. • Nasdaq peak: Investors who bought at peak on March 10, 2000, took over 15 years until
• Asset Backed Securities (ABS): MBS is a specific example of ABS, which involves pooling
May 1, 2015, just to break-even.
Market Based Regulation various assets.
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• SO2 allowances traded through the Chicago Board of Trade, allowing utilities flexibility • Risk Mixing: Allows creation of new investments with varying risk levels, attracting
in emission management.
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disinterested investors.
• Utilities receive annual allowances based on historical consumption, with options to
purchase allowances for future use. • Deep-rooted Problem: Retail banks passing mortgages to investment banks for MBS
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• The market incentivizes emissions reduction through innovation, driving down packaging reduced incentive for due diligence, contributing to crisis.
compliance costs and promoting sustainability.
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• Incentives of Investment Banks (IBs): IBs had little incentive to scrutinize composing
mortgages as they sold tranches once packaged, reducing due diligence.
Benefits and Flexibility
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• Reduced emissions improve air quality and public health while lowering energy prices • Role of Rating Agencies: Competitive pressure led to inflated ratings for MBS tranches
for consumers. as agencies competed for profitability.
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• Flexibility in allowance trading enables utilities to adapt to economic changes and • Government Reluctance: Governments reliant on tax revenue from construction and real
technological advancements. estate industries were hesitant to act against suspected housing bubble.
• Unused allowances can be sold, creating financial incentives for emissions reduction and
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innovation. • Impact of Products like Adjustable Rate Mortgages (ARMs): ARMs, offering low initial
interest rates that increased over time, caused unexpected cash-flow stress and defaults
Overall Success in MBS portfolios.
• Acid Rain Program demonstrates the efficacy of market-based environmental regulation, • Pressure on MBS Prices: Growing risk on balance sheets due to unsold MBS led to
achieving significant emissions reductions while promoting economic sustainability. buildup of toxic assets.
• Market Breakdown: Lehman Brothers and other institutions left holding toxic assets Avoiding a Crisis The Sarbanes Oxley Act (2002)
faced insolvencies, leading to contagion and ultimately the Great Recession spreading
from Wall Street to Main Street.
• Austrian School (Hayek economics): Emphasizes free market economy (Laissez Faire) • Arthur Andersen's Failure: Failure to report high-risk accounting practices at Enron led to
and believes any intervention distorts price equilibrium and surplus, viewing it as not one of the largest frauds in history, approximately $40 billion USD.
preventive.
• Sarbanes-Oxley (SOX) Act of 2002: Created in response to Enron and Worldcom
• Hayekian economists argue that avoiding pain today may lead to greater misery scandals, aimed to empower the Securities Exchange Commission (SEC) to pass
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tomorrow. regulations with criminal penalties for corporate misconduct.
Keynesian School: Advocates for government intervention to stabilize the economy,
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• • Focus of the Act: Primarily targets public companies, public accounting firms, and
with the government affecting aggregate demand. behavior of board of directors, with some provisions applying to privately held
• Keynesian economists argue for policy adjustments to prevent crises
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companies.
• Provisions of the Act: Limit destruction of evidence, require officers to certify
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accounting statement integrity, and increase auditor independence to prevent scandals.
Whistleblower Protection: SOX Act protects whistleblowers from retaliation and allows
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•
for claw-back of executive compensation for misconduct.
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Dodd Frank Wall Street Reform Act (2010) Canadian Regulations Additional Things to Know
• Efficient Market Hypothesis: The belief that prices reflect all available information.
• Dodd-Frank Wall Street Reform Act: Aimed to curb excessive risk-taking leading to the • Magnitsky Act: Adopted by Canada after death of lawyer Mr. Magnitsky in a Russian • Behavioral finance: Analyzes how psychological factors impact financial decisions and
2008 financial crisis. prison, allows states to seize assets of foreigners involved in human rights violations. market behavior, focusing on biases and irrationality in investors' choices.
• Focus of the Act: Regulation of financial entities involved in the crisis, including credit • Basel III Accords: Proposed after 2007/8 financial crisis to strengthen banking system, • Moral hazard: Refers to the increased risk-taking behavior by individuals or entities
rating agencies, investment banks, mortgage lenders, and insurance companies. includes Non-Viability Contingent Capital (NVCC) like Conditional Convertible when they are protected from the consequences of their actions, often due to insurance
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Bonds (CoCos). or bailouts
• Political Controversy: Proposed by Democrats, faced opposition from US Republicans
o In financial markets, moral hazard can lead to excessive risk-taking by investors or
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who argued it could reduce competitiveness of US capital markets. o NVCC: Aims to address the issue of "too big to fail" banks and prevent taxpayer-
institutions who believe they will be bailed out in case of failure, contributing to
funded bailouts.
• Rollback under Trump Presidency: In 2018, some provisions of Dodd-Frank were relaxed, market bubbles and crashes.
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reducing regulations on financial institutions. o CoCos: CoCos are bonds that convert to equity if a distressed firm, like a bank,
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• Tragedy of Commons: Describes individuals acting in self-interest depleting a shared
faces financial strain, shifting risk from taxpayers to investors who must price it
• Important Elements: Establishment of the Financial Stability Oversight Council to resource.
into capital costs.
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monitor "too big to fail" firms and limit systematic risk.
• Volker Rule: Designed to restrict banks' proprietary trading and investment in hedge
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funds or private equity, but was rolled back in 2020.
Free Markets
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• Market Failures: Despite structured approaches, historical instances show markets can
fail, often leading to regulatory interventions.
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o Market failure: free market system does not allocate resources efficiently or
produce the optimal outcome.
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• Free Market Philosophy: Stemming from Adam Smith's invisible hand argument,
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suggests that in absence of interference, prices rise and fall to allocate resources
efficiently.
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• Pareto Efficiency: Market ideally maximizes benefits without waste of resources, but
fairness in distribution is not guaranteed.
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COMM 221: Financial Markets COMM 221: Financial Markets COMM 221: Financial Markets

Exercise 1 Effective annual rate (continuous) 𝐸𝐴𝑅 = 𝑘"!!#"$ = 𝑒 ./0 − 1

Growing Annuities and Perpetuities Net Present Value Exercise 9

Depletable Projects Chapter 2: Personal Finance Calculating Income Tax

Instalment Loans Chapter 3: Bond and Equity Valuation Exercise 1

Expected Returns 8.2 Measuring Risk Exercise 3

Portfolio Theory Covariance

Portfolio Expected Return between two stocks.

𝐸𝑅& = Σ(𝑤) × 𝐸𝑅) )

Correlation Coefficient Perfect Correlations Systematic and Unsystematic Risk

CAPM and The Security Market Line Exercise 9 Multifactor Models

𝑅) = 𝑅𝑓 + 𝛽1 (𝑅% − 𝑅𝑓) + 𝛽2 (𝑆𝑀𝐿) + 𝛽4 (𝐻𝑀𝐿) + 𝛽6 (𝑅𝑀𝑊) + 𝛽7 (𝐶𝑀𝐴)

Preference Towards Risk Exercise 11 Chapter 5: Supply and Demand

Economic Surplus Exercise 1 Government Interventions/Distortions

Exercise 3 Exercise 4 Exercise 5

𝑃+ = 200 − 0.2𝑄 𝑃+ = 200 − 0.2𝑄 𝑃+ = 200 − 0.2𝑄

Elasticity Efficiencies Chapter 6: Historical Events

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