Prof. John Cotter Centre For Financial Markets (CFM) University College Dublin

CORPORATE FINANCE
Prof. John Cotter

Centre for Financial Markets (CFM)
University College Dublin
John Cotter UCD 2010 1

Course Outline
• Introduction and Overview
• Portfolio Theory and Asset Pricing Models
• Derivative Markets
• Fixed Income Securities
• Evaluating the Investment Process

Course Assessment
• Group Project (40%)
• Individual Assignments (60%)

Importance of Course
• Course deals with ‘MARKETS’
• (Financial) Markets provide information eg. Good
vs bad – provide signals
• Financial markets suggest analysis – decision
making based on rigorous rules
• Financial markets provide avenue to optimise
allocation of balance sheet assets
• Financial markets provide avenue to manage
balance sheet liabilities efficiently

Importance of Course
• Finance theories have been developed to
help us understand workings of market
• Finance theories offer methods of
maximising use of market information
• Finance theories and market based analysis
help us to make optimal decisions that
maximise the potential of our firm

INTRODUCTION AND
OVERVIEW
Prof. John Cotter

Security Products, Security
Markets and Security Players

INTRODUCTION
• Investment environment - what/where/who?
• investment process - procedure for
developing strategies
• investment involves risk and return - course
deals with these under a number of
headings
eg individual asset vs many assets
eg. real investment vs financial investment
Types of markets
• Transactions take place in markets
• meeting place for buyers and sellers
• distinction can exist:
– eg. primary - issue shares vs secondary -
trade shares
– eg. Equity vs derivative
– eg. Money vs capital
Types of assets
• Security - legal representation of the right to
receive prospective future benefits under
stated conditions
• security involves passing of time -
• rate of return: r = (p1 - p0)/ p0
where r
= the rate of return
p0 = the beginning price
or use w - wealth (see example)
Types of assets
• treasury bills - short term, low return
• government bonds - long term, govt
guaranteed, low return
• Corporate Bonds - long term, large firms,
low return
• Common stock - high return - two types,
high risk

Types of assets
• Returns should be seen in context of
inflation
• note risk and return trade-off
• assets combined together in portfolio -
• receive average return of assets
• receive < average risk of assets
•  diversification possible
Investment process
• Procedure for developing and managing
investment strategies:
– set investment policy - objective(s)
– perform security analysis - eg. Technical analysis,
fundamental analysis
– construct portfolio - choice
– revise portfolio
– evaluate performance - risk and return outcomes

ASSETS + TRADING
CHARACTERISTICS
• Players - eg. Broker - acts as agents of
investors and compensated by commission
• Different types of brokers deal with
different types of investors

Trading Charcteristics
• Securities are traded on exchanges as they
have been issued by PLC’s
• new shares issued in primary markets
• Issuing PLC receives proceeds from sale
• Issued shares then trade on secondary
market

Types of Issue
• Public Offering - shares issued to ordinary
investor - popular method, discount may
exist
• Initial Public Offer - first issue by firm -
underpricing exists, performance of IPO’s
poor
• Private placement - sale of security to
investors after private negotiations -
discount offered,Johnused for
Cotter UCD 2010bond issue 16
Process of Trade
• Ordinary - size, practical aspects, types of
order
• margin buying - rational + explanation,
features, example
• short sales - rational + explanation, features,
example

Ordering
• Types of orders -
• eg. Market order - broker asked to complete
investor request immediately and buy/sell at best
price available
• eg. Limit order - max/min price set by investor
• eg. Stop order - used to enure a certain return on
equity - order completed after price reaches
threshold

Margin Buying
• Investor uses credit to buy security - borrows from
broker, deals on a/c, encourages greater market
participation
• Features of margin buying -
– initial margin deposit
– maintenance margin - minimum threshold that
equity can reach before investor must add
additional funds - used to ensure against default

Short Sales
• - a sale involving the investor borrowing
stock from broker to sell now at high price
and replace later at lower price
• Features of short sales:
– investor borrows stock
– investor sells stock and deposits proceeds
– short sales only allowed for up-tick rule
– investor closes position by purchasing and
replacing stock at lower price
Markets and Products
• Types of markets
• examples of major markets
• examples of minor markets
• type of products

Types of markets
• Call - market open for specified time vs.
continuous - market open for a trading day
• money vs capital market - deals with
security distinctions eg. Debt instruments vs
equity

Examples of Markets
• Organised Exchanges
• Over the Counter (OTC)
• Third and Fourth Market

Irish Markets
• EG of minor markets - Irish Stock
Exchange:
• very small - thin trading
• very few companies raising capital
• primary and secondary markets exist
• market generally volatile
• future uncertain
Market Framework

Market Framework
• Examining Theory of Market Operation
• Market Demand - price and quantity
• market supply - price and quantity
• Exchange at Equilibrium - through different
systems
- agreement and trade is completed.

Market Framework
• Change in demand eg. Income/
EXPECTATIONS/change in price of related
products
• change in supply eg.
EXPECTATIONS/Change in costs of
inputs/ change in structure of industry
• change in equilibrium - change in price/
change in quantity

MARKET DEMAND
• HOW IS THE DEMAND FOR
SECURITIES DETERMINED?
– Definition: the demand for a security is a
schedule of prices and quantities demanded by
investors at all possible prices.
– the demand is determined by summing the
individual schedules for all investors in the
market

MARKET DEMAND
• Price and quantity negatively related - law
of demand
• Demand curve shows relationship between
price and quantity demanded (ceteris
paribus) - see diagram

The Market Demand Schedule
for ABC Stock
$120
$100
$80
$60 ABC
$40
$20 D
$0
10 20 30 40

MARKET SUPPLY
• Market Supply - supply of asset can be
described by schedule of prices and
quantity supplied
• Quantity supplied and price positively
related - law of supply
• Market supply is combination of all
individual investors supply schedules
• supply curve shows relationship between
price and quantity supplied of asset
MARKET SUPPLY
• HOW IS THE SUPPLY OF SECURITIES
DETERMINED?
– Individual brokers hold a collection of market
orders to sell at all possible prices
– In combining the market orders, the resulting
market supply graph curves upward and to the
right

The Market Supply Schedule for
ABC Stock
$120
$100
$80
$60 ABC
$40
$20
$0
10 20 30 40

EXCHANGE AT
EQUILIBRIUM
• Equilibrium due to interaction of supply and
demand
• market equilibrium is combination of all
individual equilibriums at unique prices and
quantities
• EG. an open outcry system begins as
– the clerk calls out the prices for ABC
– if no buyer, clerk goes to next lower price
– if no seller, clerk raises price
– prices are called until the quantity demanded equals the quantity
supplied at the “right price.”

How Market Price Is Determined
for ABC Stock
120
100
80
buyers
60
sellers
40
20
0
10 20 30 40

MARKET DEMAND AND
SUPPLY
• Changes in Demand - 1. Movement on courve -
price change, 2. Shift in curve – EXPECTATIONS
CHANGE, income change, change in price of
related products
• Change in supply - 1. Movement on curve - price
change, 2. Shift in Curve – EXPECTATIONS
CHANGE, input price change, change in industry
structure
• change in equilibrium - change in price and
quantity
Outcomes of Market

OUTCOMES OF MARKET
• Price and quantity
• Return - ex-post return, ex-ante return,
measured in %, return on single asset/
return on portfolio of assets
• Risk - measure of dispersion of returns,
many measures (eg. Standard deviation,
variance, range), individual asset risk/
portfolio risk - diversification effects
• Outcomes change according to asset type
Rates of Return: Single Period
HPR  P P D
1 0 1
P 0
HPR = Holding Period Return

P1 = Ending price
P0 = Beginning price
D1 = Dividend during period one (may
be excluded) John Cotter UCD 2010 39
Individual Asset Rates of Return:
Single Period Example
Ending Price = 24
Beginning Price = 20
Dividend = 1
HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

Return on a Portfolio (#1)
The rate of return on a portfolio is a weighted average of the
rates of return of each asset comprising the portfolio, with
the portfolio proportions as weights.
rp = W1r1 + W2r2
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r2 = Expected return on Security 2

Return on a Portfolio (#2)
» Taking account of the composition of the
portfolio in terms of the different assets that
make up w1 and wo gives:
rP = w1 - w0/ w0

PORTFOLIO RISK
• Portfolio Risk: a measure that estimates the
extent to which the actual outcome is likely
to diverge from the expected outcome
• Portfolio risk looks at the benefits of

diversification - portfolio risk less than
weighted average of each assets risk

PORTFOLIO RISK
When two risky assets with variances s12 and s22,
respectively, are combined into a portfolio with
portfolio weights w1 and w2, respectively, the
portfolio variance is given by
p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)
Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK
– Portfolio Risk:
• COVARIANCE
– DEFINITION: a measure of the relationship between two
random variables
– possible values:
» positive: variables move together
» zero: no relationship
» negative: variables move in opposite directions

PORTFOLIO RISK
• CORRELATION COEFFICIENT
– rescales covariance to a range of +1 to -1
 ij   ij i  j
 ij   ij /  i
where
j

Correlation Coefficients:
Possible Values
Range of values for  12
+ 1.0 >  12 > -1.0
If  12 = 1.0, the securities would be
perfectly positively correlated
If  12 = - 1.0, the securities would be
perfectly negatively correlated
Two-Security Portfolio
E(rp) = W1r1 + W2r2
p2 = w12  12 + w22  22 + 2W1W2 Cov(r1r2)
 p = [w12  12 + w22  22 + 2W1W2 Cov(r1r2)]1/2

Three-Security Portfolio
rp = W1r1 + W2r2 + W3r3
 2p = W12  1+
2
W22  22 + W32  32
+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
OUTCOMES OF MARKET
• Expected Risk and Return variables can
also be measured using subjective
probabilities
• All outcomes are determined according to
likelyhood (probability) of occurrence

PORTFOLIO THEORY AND
ASSET PRICING MODELS
Prof. John Cotter

Portfolio Theory and Portfolio
Selection
• Portfolio Selection: involves choices from
alternative combinations of assets
• Most assets involve uncertain (risky) future so
choice must incorporate risk in decision making
process
• Markowitz provides possible solution to choice
made -
• the key to Markowitz theory is that investors gain
from diversification

Portfolio Selection
• MARKOWITZ PORTFOLIO RETURN
– portfolio return (rp) is a random variable

– defined by the first and second moments of the
distribution
• return
• standard deviation

THE MARKOWITZ
APPROACH
• Assumptions underlying Portfolio Selection
– First Assumption:
• nonsatiation: investor always prefers a higher rate
of portfolio return
– Second Assumption
• assume a risk-averse investor will choose a portfolio
with a smaller standard deviation
• investor does not like uncertainty

THE MARKOWITZ
APPROACH
– Third Assumption:
• Investors want to maximise Utility
• INVESTOR UTILITY : is the relative satisfaction
derived by the investor from the economic activity.
• It depends upon individual tastes and preferences
• It assumes rationality, i.e. people will seek to
maximize their utility
• Wealth and utility are positively related
• Marginal Utility measure additional Utility from
additional wealth

THE MARKOWITZ
APPROACH
• MARGINAL UTILITY
– each investor has a unique utility-of-wealth
function
– incremental or marginal utility differs by
individual investor
– Assumes
• diminishing characteristic - investor risk averse
• nonsatiation
• Concave utility-of-wealth function

Utility and Portfolio Selection
• Utility and portfolio selection can be
analysed through indifference curves
• Indifference curves are a graphical
representation of a set of various risk and
expected return combinations that provide
the same level of utility
• investor indifferent between combinations
of risk and return on indifference curve

Types of Stock Analysis
• Technical Analysis - using prices and volume information
to predict future prices
– Weak form efficiency & technical analysis - technical analysis
works if market is not weak form efficient
• Fundamental Analysis - using economic and accounting
information to predict stock prices
– Semi strong form efficiency & fundamental analysis - analysis
works if market is not semi strong form efficient

Market Efficiency
• Investment in securities examines price behaviour
• Do securities prices reflect information? Yes -
market efficient, No - market inefficient
• Market Efficiency determines whether market can
process information efficiently
• Three forms of Market Efficiency (see Diagram)

MARKET EFFICIENCY
THE EFFICIENT MARKET
MODEL
public information
all
insider information
information

Forms of the EMH
• Weak - Asset prices reflect all info from previous

prices and volume
• Semi-strong - Asset prices reflect all current
publicly available info
• Strong - Asset prices reflect all info - private and
public
• Market is efficient if investor is unable to make
abnormal profits from analysis of information set
(price/public and private info)
Example of Efficiency Model
• In an efficient market the new information is
incorporated into prices immediately.
• positive and negative information are as equally
probable
• if temporary inefficiencies cause mispricing,
investors seeking profit opportunities eliminate the
opportunities

• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– Investors will make a fair return but no more on
their investments
– by searching for inefficiencies, investors insure
market efficiency
– publicly known investment strategies cannot
generate abnormal returns

• SUMMARY OBSERVATIONS ABOUT
EFFICIENT MARKETS:
– some investors will display impressive
performance records
– professional investors should fare no better than
ordinary investors when selecting securities
– past performance is not an indicator of future
performance

Information Processing in
Markets
• How do markets process new info?
• In efficient markets the content of the new
info is understood correctly and is
incorporated into new prices immediately
• Info can be positive or negative but we do
not know in advance  asset prices follow
a random walk

Random Walk and the EMH
• Random Walk - stock prices are random
• Expected price is positive over time
• Positive trend and random about the trend

Random Walk with Positive
Security
Trend
Prices
Time
Random Price Changes
Why are price changes random?
• Prices react to information
• Flow of information is random
• Therefore, price changes are random

EMH and Competition
• Stock prices fully and accurately reflect publicly
available information
• Once information becomes available, market
participants analyze it
• Competition assures prices reflect information

Empirical Tests of Market
Efficiency
• Event studies - semi strong form efficiency -
evidence suggests anomalies exist eg. Small firm
effect, january effect, earnings announcements,
stock market crashes
• Assessing performance of professional managers
• Testing some trading rule - weak form effiecieny -
testing random walk - evidence suggests that for
RETURNS: positive correlation (short run) and
negative correlation (long run)

How Tests Are Structured
1. Examine prices and returns over time

Returns Over Time
-t 0 +t
Announcement Date
(cont’d)
2. Returns are adjusted to determine if they are
abnormal
Market Model approach
a. Rt = at + btRmt + et
(Expected Return)
b. Excess (ABNORMAL) Return =
(Actual - Expected)
et = Actual - (at + btRmt)

(cont’d)
2. Returns are adjusted to determine if they
are abnormal
Market Model approach
c. Cumulate the excess returns over time:
-t 0
John Cotter UCD 2010
+t
74
Portfolio Analysis
• Markowitz - investor want to max utility
• Analysis wants to choose assets from
infinite portfolio
• Feasible set - all portfolios
• choose efficient set - max return for given
risk and/or min risk for given return

DIVERSIFICATION
• TOTAL PORTFOLIO RISK
– also has two parts: market and unique
• Market Risk
– diversification leads to an averaging of market risk
• Unique Risk
– as a portfolio becomes more diversified, the smaller will
be its unique risk

DEFINING THE RISK FREE
ASSET
• DOES A RISK FREE ASSET EXIST?
– CONDITIONS FOR EXISTENCE:
• Fixed-income security
• No possibility of default
• No interest-rate risk
• no reinvestment risk
– Given the conditions, what qualifies?
• a U.S. Treasury security with a maturity matching
the investor’s horizon

Allocating Capital Between
Risky
& Risk Free Assets
• Possible to split investment funds between
safe and risky assets
• Risk free asset: proxy; T-bills
• Risky asset: stock (or a portfolio)

Risky & Risk Free Assets (cont.)
Issues
• Examine risk/ return tradeoff
• Demonstrate how different degrees of
risk aversion will affect allocations
between risky and risk free assets

Risky
& Risk Free Assets (EG)
rf = 7% rf = 0%
E(rp) = 15% p = 22%
y = % in p (1-y) = % in rf

Expected Returns for
Combinations
E(rc) = yE(rp) + (1 - y)rf
rc = complete or combined portfolio
For example, y = .75

E(rc) = .75(.15) + .25(.07)
= .13 or 13%
Possible Combinations
E(r)
E(rp) = 15%
P
E(rc) = 13%
C
rf = 7%
F

0  c
22% 82
Variance on
the Possible Combined Portfolios
Since  r = 0, then
f
 c = y* p

Combinations Without Leverage
If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = (.22) = .00 or 0%
Using Leverage and
Capital Allocation Line
Capital Allocation line - represents investment
opportunity set (all risk-return combinations
available to investor)
Assume that you can Borrow at the Risk-Free
Rate and invest in stock
Using 50% Leverage
rc = (-.5) (.07) + (1.5) (.15) = .19
c = (1.5) (.22) = .33
CAL (Capital Allocation Line)
E(r)
P
E(rp) = 15%
E(rp) - rf = 8%
) S = 8/22
rf = 7%
F

0 p = 22%
Risk Aversion and Allocation
• Greater levels of risk aversion lead to larger
proportions of the risk free rate
• Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets
• Willingness to accept high levels of risk for high
levels of returns would result in leveraged
combinations

CAL with Risk Preferences
E(r)
Borrower
7%
Lender

p UCD
John Cotter = 22%
2010 88
ASSET PRICING MODELS
• Capital Asset Pricing Model (CAPM)
• Factor Models
• Arbitrage Pricing Theory

Capital Asset Pricing Model
(CAPM)
• Equilibrium model that underlies all modern
financial theory
• Derived using principles of diversification with
simplified assumptions
• Markowitz, Sharpe, Lintner and Mossin are
researchers credited with its development

Assumptions (NOTE
MARKOWITZ)
• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded financial
assets
• No taxes, and transaction costs
• Nonsatiation
• Assets are infinitely divisble
Assumptions (cont’d)
• Information is costless and available to all
investors
• Investors are rational mean-variance
optimizers
• Investors are risk averse
• Homogeneous expectations

Resulting Equilibrium
Conditions
• All investors will hold the same portfolio
for risky assets – market portfolio
• Market portfolio contains all securities and
the proportion of each security is its market
value as a percentage of total market value

Resulting Equilibrium
Conditions (cont’d)
• Risk premium on the market depends on the
average risk aversion of all market
participants
• Risk premium on an individual security is a
function of its covariance with the market

CAPM Revisited
CAPM: Cost of Capital = rf + (rm – rf)
Where rf is the risk free rate
rm is the return on the market portfolio
 is the extent to which the project is risky
relative to the market benchmark
• Used in deciding whether to invest or not

THE CAPITAL MARKET LINE
• THE CAPITAL MARKET LINE (CML)
– the new efficient frontier that results from risk
free lending and borrowing
– both risk and return increase in a linear fashion
along the CML

Capital Market Line
E(r)
CML
M
E(rM)
rf
p
m
Slope and Market Risk Premium
M = Market portfolio
rf = Risk free rate
E(rM) - rf = Market risk premium
E(rM) - rf = Market price of risk

M
= Slope of the CAPM
E ( rM )  rf
rp  rf  [ ]
 m
2 pm

THE MARKET PORTFOLIO
• DEFINITION: the portfolio of all risky
assets which contains
– complete diversification
– a central role in the CAPM theory which is the
tangency portfolio (M) with the CML

THE SECURITY MARKET
LINE (SML)
• FOR AN INDIVIDUAL RISKY ASSET
– the relevant risk measure is its covariance with
the market portfolio (si, M)
– DEFINITION: the security market line
expresses the linear relationship between
• the expected returns on a risky asset and
• its covariance with the market returns
r  r   [ E( r )  r ]
i f i M f
Security Market Line
E(r)
SML
E(rM)
rf
ß
ß = 1.0
Sample Calculations for SML
E(rm) - rf = .08 rf = .03
x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%
y = .6
e(ry) = .03 + .6(.08) = .078 or 7.8%
Graph of Sample Calculations
E(r)
SML
Rx=13% .08
Rm=11%
Ry=7.8%
3%
ß
.6 1.0 1.25
ß ß ß
yJohn Cotterm
UCD 2010 x 103
Disequilibrium Example
E(r)
SML
15%
Rm=11%
rf=3%
ß
1.0 1.25
• Suppose a security with a  of 1.25 is
offering expected return of 15%
• According to SML, it should be 13%
• Underpriced: offering too high of a rate of
return for its level of risk

THE MARKET MODEL
– assumed return on a risky asset was related to
the return on a market index
ri   iI   i1rI   iI

THE MARKET MODEL
• DIFFERENCES WITH THE CAPM
– the market model is a single-factor model
– the market model is not an equilibrium model
like the CAPM
– the market model uses a market index,
– the CAPM uses the market portfolio

THE MARKET MODEL
• MARKET (AND NON-MARKET RISK)
– according to the CAPM
• the relationship is identical except the market
portfolio is involved instead of the market index

THE MARKET MODEL
– Why partition risk?
• market risk
– related to the risk of the market portfolio and to the beta
of the risky asset
– risky assets with large betas require larger amounts of
market risk
– larger betas mean larger returns

THE MARKET MODEL
– Why partition risk?
• non-market risk
– not related to beta
– risky assets with larger amounts of s will not have
eI
larger E(r)
• According to CAPM
– investors are rewarded for bearing market risk not non-
market risk

FACTOR MODELS (INDEX
MODELS) AND RETURN-
GENERATING PROCESSES
• FACTOR MODELS -
DEFINITION: a model of a return-generating
process that relates returns on securities to
the movement of one or more common
factors
– assume returns of two securities are correlated
in some way

FACTOR MODELS AND RETURN-
GENERATING PROCESSES
– any unexplained aspects of a return are
assumed to be
• unique
• uncorrelated with the unique aspect of other
securities

THE MARKET MODEL
• THE MARKET MODEL
– is a specific example of a factor model
– the general form may be written
r i = ai, I + bi, rI + e i, I
where the factor is the market index (I)
rI is the i th return in the market

MULTIPLE-FACTOR MODELS
• use more than one explanatory variable in
the return-generating process
• some of these factors may include
• THE GROWTH RATE OF GDP
• THE LEVEL OF INTEREST RATES
• THE YIELD SPREAD BETWEEN CERTAIN
VARIABLES
• THE INFLATION RATE
• THE LEVEL OF OIL PRICES

MULTIPLE-FACTOR MODELS
• SECTOR-FACTOR MODELS
– Assumption:
• prices may move together for the same industry or
economic sector
• SECTOR-FACTOR MODELS
– sectors possible
• utilities
• transportation
• financial

Arbitrage Pricing Theory
Arbitrage - arises if an investor can construct a zero
investment portfolio with a sure profit
• Since no investment is required, an investor can
create large positions to secure large levels of
profit (use arbitrage portfolio)
• In efficient markets, profitable arbitrage
opportunities will quickly disappear
• APT is an equilibrium factor model of security
returns

Arbitrage Portfolios
• requires no additinal investor funds
eg. 3 asset portfolio: X1 + X2 + X3 = 0
X represents change in investment for each asset.
• no factor sensitivity:
b1X1 + b2X2 +b3X3 = 0
• has positive expected returns

X1E(r1) + X2E(r2) + X3E(r3)  0
FACTOR MODELS
• ARBITRAGE PRICING THEORY (APT)
– Three Major Assumptions:
• capital markets are perfectly competitive
• investors always prefer more to less wealth
• price-generating process is a K factor model

FACTOR MODELS
• MUTIPLE-FACTOR MODELS
– FORMULA
ri = ai + bi1 F1 + bi2 F2 +. . .
+ biKF K
where r is the return on security i
b is the coefficient of the factor
F is the factor

FACTOR MODELS
• SECURITY PRICING
– FORMULA:
ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK
where
ri = rRF +(d1-rRF )bi1 + (d 2-
rRF)bi2+ . . .
+(d-rRF)biK
FACTOR MODELS
where r is the return on security i

l0 is the risk free rate
b is the factor
a stock’s expected return is equal to
the risk free rate plus k risk premiums based
on the stock’s sensitivities to the k factors

E(r)%
10
D A
7
6
C
Risk Free 4
.5 1.0 Beta

• Short Portfolio C
• Use funds to construct an equivalent risk
higher return Portfolio D
– D is comprised of A & Risk-Free Asset
• Arbitrage profit of 1%

APT and CAPM Compared
• APT applies to well diversified portfolios and not
necessarily to individual stocks
• With APT it is possible for some individual stocks to be
mispriced - not lie on the SML
• APT is more general in that it gets to an expected return
and beta relationship without the assumption of the market
portfolio
• APT can be extended to multifactor models

DERIVATIVE MARKETS
Prof. John Cotter


FUTURES CONTRACTS
• WHAT ARE FUTURES?
– Definition: an agreement between two
investors under which the seller promises to
deliver a specific asset on a specific future date
to the buyer for a predetermined price to be
paid on the delivery date
– Many assets types have futures contracts eg.
Currencies, commodities (agricultural, natural
resources), fixed income securities etc

HEDGERS AND
SPECULATORS
• MARKET PARTICIPANTS (2 or 3)
– HEDGERS are traders who buy or sell to offset
a risk exposure in the spot market
– SPECULATORS are traders who buy or sell
futures contracts for the potential of arbitrage
profits (note Speculators include arbitrageurs)
– Return and risk profile of futures reasonably
similar to underlying assets

THE FUTURES MARKET
• THE CLEARINGHOUSE
– FUNCTIONS:
• provide orderly and stable meeting place for buyers
and sellers
• prevents losses from defaults
– Procedures
• imposes initial and daily maintenance margins
• marks to market daily

THE FUTURES MARKET
• THE CLEARINGHOUSE
– MAINTENANCE MARGIN
• investor keeps the account’s equity equal to or
greater than a certain percentage
• if not met, margin call is issued to the buyer and
seller
• variation margin
– represents the additional deposit of cash that brings the
equity up to the margin

THE FUTURES MARKET
• MARKING TO MARKET -the process of
adjusting the equity in an investor’s account in
order to reflect the change in the settlement price
of the futures contract
– Process
• each day the clearinghouse replaces the existing contracts with
new ones
• the purchase price = the settlement price that day
• the amount of the investor’s equity may change daily

BASIS
• WHAT IS THE BASIS?
– DEFINITION: basis is the current spot price
minus the current futures contract price
– Current spot price is the price of the asset for
immediate delivery
– the current futures contract price is the purchase
price of the contract in the market

BASIS
• SPECULATING ON THE BASIS
– Basis risk
• the risk that the basis will narrow or widen
– speculating on the basis means an investor will
want to be either
• short in the futures contract and long in the spot
market (BASIS WIDENS), or
• long in the futures contract and short in the spot
market (BASIS NARROWS)
FUTURES PRICES AND
FUTURE SPOT PRICES
• CERTAINTY
– Future spot price forecasts have no certainty
because if so
• the purchase price would equal the spot
• the purchase price would not change as delivery
neared
• no need for margin or price limit system

FUTURES PRICES AND
FUTURE SPOT PRICES
• UNCERTAINTY
– How are futures prices related to expected spot
prices? Alternative theories available
• EXPECTATION HYPOTHESIS
– the current futures purchase price equals the consensus
expectation of the future spot price
Pf = Ps
where Pf is the current purchase price of the futures
Ps is the expected future spot price at delivery

FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL BACKWARDATION
– KEYNES: criticized the expectation hypothesis
and stated that
• hedgers will want to be short futures
• this entices speculators to go long in the futures
markets
• to do this speculators make the expected return from
a long position greater that the risk free rate

FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL BACKWARDATION
– which can be written
Pf < Ps
– this relationship known as normal backwardation
– which implies Pf can be expected to rise during the

life of the futures contract
FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL CONTANGO
– a contrary hypothesis to Keynes
– states that on balance hedgers want to go long in the
futures and entice speculators to be short in the futures
– to do this hedgers make
Pf > Ps
– this implies that Pf can be expected to fall during its contract life

FUTURES PRICES AND
FUTURE SPOT PRICES
• NORMAL BACKWARDATION AND
Pf
CONTANGO
PS

FUTUTES PRICES AND
CURRENT SPOT PRICES
• AT WHAT PRICE SHOULD FUTURES
CONTRACTS SELL?
Pf = Ps + I
where Pf = futures contract price
Ps = current spot asset price
I = the dollar amount of interest
corresponding to the period
of time from present to delivery
date
FUTUTES PRICES AND
CURRENT SPOT PRICES
– Benefits of ownership
• What if there are benefits that accrue to owner of
the asset, then
Pf = Ps + I - B
where B is the benefit

FUTUTES PRICES AND
CURRENT SPOT PRICES
• COST OF OWNERSHIP
– What if there are costs that accrue due to
owning the asset?
Pf = Ps + I - B + C
where C is the cost of owning

FUTUTES PRICES AND
CURRENT SPOT PRICES
• COST OF OWNERSHIP
– The Cost of Carry (I-B+C)
• the total value of interest less benefits received plus
cost of ownership
– The Futures Price
• can be greater or less than the spot price depending
on whether the cost of carry is positive or negative

TYPES OF OPTION
CONTRACTS
• WHAT IS AN OPTION?
– Definition: a type of contract between two
investors where one grants the other the right to
buy or sell a specific asset in the future
– the option buyer is buying the right to buy or
sell the underlying asset at some future date
– the option writer is selling the right to buy or
sell the underlying asset at some future date

EXAMPLE OF OPTION
CONTRACT
– A call option contract is the legal contract that specifies
conditions of trading in option
– CONDITIONS
• the company whose shares can be bought
• the number of shares that can be bought
• the purchase price for the shares known as the exercise or
strike price
• the date when the right expires
In US exchanges created the Options Clearing Corporation
(CCC) to facilitate trading a standardized contract (100
shares/contract)

OPTION TRADING
• FEATURES OF OPTION TRADING
– new options are offered on 3 month cycle
– Option life varies (eg. 1 year vs 2 year
– once listed, the option remains until expiration
date
– option trading use specialist and market makers

THE VALUATION OF OPTIONS
• CALL VALUATION AT EXPIRATION
E
+100
value
of
option
0 200
100
stock price
• CALL VALUATION AT EXPIRATION
– ASSUME: the strike price = $100
– For a call if the stock price is less than $100,
the option is worthless at expiration
– The upward sloping line represents the intrinsic
value (IV) of the option

• PUT VALUATION AT EXPIRATION
value 100
of
the
option
E=100
0 stock price

• PROFITS AND LOSSES ON CALLS
PROFITS
CALLS
100 p
0
LOSSES
THE BINOMIAL OPTION
PRICING MODEL (BOPM)
• WHAT DOES BOPM DO?
– it estimates the fair value of a call or a put option
• ASSUME THAT OPTION IS EUROPEAN
(RELAX LATER FOR AMERICAN)
– EUROPEAN is an option that can be exercised only on
its expiration date
– AMERICAN is an option that can be exercised any
time up until and including its expiration date

THE BINOMIAL OPTION
• EXAMPLE: CALL OPTIONS
– ASSUMPTIONS:
• price of Widget stock = $100
• at current t: t=0
• after one year: t=T
• stock sells for either
$125 (25% increase)
$ 80 (20% decrease)
• Annual riskfree rate = 8% compounded continuously
• Investors can lend or borrow through an 8% bond

THE BINOMIAL OPTION
• Consider a call option on Widget
Let the exercise price = $100, the exercise date = T, and
the exercise value:
If Widget is at $125 = $25
or at $80 = 0
• What is a fair value for the call at time =0?
• Two Possible Future States
– The “Up State” when payoff = $125
– The “Down State” when payoff = $80
– Fair value between 0 and $25 got from solving relationships

THE BINOMIAL OPTION
PRICING MODEL (Price Tree)
Annual Analysis: $125 P0=25
$100
$80 P0=$0
Semiannual Analysis: $125 P0=25
$111.80
$100 $100 P0=0

$89.44
$80 P0=0
t=0 t=.5T
t=T 153
THE BLACK-SCHOLES
MODEL
• Estimating fair value of European call/put
for continuous time?
• How is the BOPM model affected if the
number of periods before expiration were
allowed to increase infinitely?

THE BLACK-SCHOLES
MODEL
• The Black-Scholes formula for valuing a
call option E
Vc  N (d1 ) Ps  RT
N (d 2 )
e
where
ln(Ps / E)  (R  .5 )T 2
d1 
 T
THE BLACK-SCHOLES
MODEL
ln(Ps / E )  ( R  .5 )T 2
d2 
 T
and where Ps = the stock’s current market price
E = the exercise price
R = continuously compounded risk
free rate
T = the time remaining to expire
s = risk (standard deviation of the
stock’s annual return)
THE BLACK-SCHOLES
MODEL
• NOTES:
– E/eRT = the PV of the exercise price where
continuous discount rate is used
– N(d1 ), N(d2 )= the probabilities that outcomes
of less will occur in a normal distribution with
mean = 0 and s = 1

THE BLACK-SCHOLES
MODEL
• What happens to the fair value of an option
when one input is changed while holding
the other four constant?
– The higher the stock price, the higher the
option’s value
– The higher the exercise price, the lower the
option’s value
– The longer the time to expiration, the higher the
option’s value
THE BLACK-SCHOLES
MODEL
• What happens to the fair value of an option
when one input is changed while holding
the other four constant?
– The higher the risk free rate, the higher the
option’s value
– The greater the risk, the higher the option’s
value

FIXED INCOME SECURITIES
Prof. John Cotter


OUTLINE
• Types of Fixed Income Securities
• Pricing of Fixed Income Securities -
calculating yields, term structure theories
• Analysis of Fixed Income Investments -
Bond analysis
• Analysis of Fixed Income Portfolios - Bond
Portfolio Management Analysis

Bond Characteristics
• Face or par value
• Coupon rate
– Zero coupon bond
• Compounding and payments
– Accrued Interest
• Indenture

Provisions of Bonds
• Secured or unsecured
• Call provision
• Convertible provision
• Put provision (putable bonds)

SAVINGS DEPOSITS
• COMMERCIAL BANKS
– their financial products include various fixed-
income securities, such as
• demand deposits
• time deposits
• certificates of deposit
• OTHER SAVINGS INSTITUTIONS:
– Building societies
– Credit Unions
THE MONEY MARKET
• DEFINITION: a market for buyers and sellers of
short-term (less than one year in maturity)
financial products
• MONEY MARKET INSTRUMENTS
– commercial paper
– certificates of deposit
– bankers acceptances
– eurodollars
– repurchase agreements (repos)
Government Products
• Treasury Bills
• issued on a discount basis
• maturities up to 52 weeks
• sold by auction (bid process)
• issued in large denominations
• Treasury Bonds
• maturities greater than ten years
• denominations in large dominations
• some have call provisions

CORPORATE BONDS
• MANY TYPES EG. Mortgage bond,
debentures
• THE INDENTURE
– DEFININTION: a legal document formally
describing the terms of the legal relationship
between a bond issuer and bondholders.

FOREIGN BONDS
• WHAT CONSTITUTES A FOREIGN
BOND?
– DEFINITION: foreign bonds are bond offered
in another currency outside the issuers country
of origin

INTEREST RATES
• NOMINAL V. REAL INTEREST RATES
– Nominal interest rates:
• represent the rate at which consumer can trade
present money for future money
– real interest rate
• the rate of return from a financial asset expressed in
terms of its purchasing power (adjusted for price
changes).

Bond Pricing
T
PB   C t

ParValue T
(1 r )
T
t 1 (1 r )
t
PB = Price of the bond

Ct = interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual yield to
maturity

Bond Prices and Yields
Prices and Yields (required rates of return)
have an inverse relationship
• When yields get very high the value of the
bond will be very low
• When yields approach zero, the value of the
bond approaches the sum of the cash flows

Prices and Coupon Rates
Price
Yield
Yield to Maturity
• Interest rate that makes the present value of
the bond’s payments equal to its price
Solve the bond formula for r
T
PB   C t

ParValue T
(1 r )
T
t 1 (1 r )
t

Yield to Maturity Example
20
35 1000
950   
(1 r )
T
t 1 (1 r )
t
10 yr Maturity Coupon Rate = 7%

Price = $950
Solve for r = semiannual rate r = 3.8635%

Realized Yield versus YTM
• Reinvestment Assumptions
• Holding Period Return
– Changes in rates affects returns
– Reinvestment of coupon payments
– Change in price of the bond

Holding-Period Return:
Single Period
HPR = [ I + ( P1 – P0 )] / P0
where
I = interest payment
P1 = price in one period
P0 = purchase price

Holding-Period Return:
Multiperiod
• Requires actual calculation of reinvestment
income
• Solve for the Internal Rate of Return using
the following:
– Future Value: sales price + future value of
coupons
– Investment: purchase price

YIELD CURVES
• YIELD CURVES AND TERM
STRUCTURE
– yield curve provides an estimate of
• the current TERM STRUCTURE OF INTEREST
RATES
• yields change daily as YTM change

Overview of Term Structure
of Interest Rates
• Relationship between yield to maturity and
maturity
• Information on expected future short term rates
can be implied from yield curve
• The yield curve is a graph that displays the
relationship between yield and maturity
• Three major theories are proposed to explain the
observed yield curve

Yield Curves
Yields
Upward
Sloping
Flat
Downward
Sloping
Maturity
Theories of Term Structure
• Expectations
• Liquidity Preference
– Upward bias over expectations
• Market Segmentation
– Preferred Habitat

Expectations Theory
• Observed long-term rate is a function of
today’s short-term rate and expected future
short-term rates
• Long-term and short-term securities are
perfect substitutes
• Forward rates that are calculated from the
yield on long-term securities are market
consensus expected future short-term rates

Liquidity Premium Theory
• Long-term bonds are more risky
• Investors will demand a premium for the risk
associated with long-term bonds
• Yield curve has an upward bias built into the long-
term rates because of the risk premium
• Forward rates contain a liquidity premium and are
not equal to expected future short-term rates

Liquidity Premiums
and Yield Curves
Yields Observed Yield
Curve
Forward Rates
Liquidity
Premium
Maturity
Market Segmentation
and Preferred Habitat
• Short- and long-term bonds are traded in distinct markets
• Trading in the distinct segments determines the various
rates
• Observed rates are not directly influenced by
expectations
• Preferred Habitat
– Modification of market segmentation
– Investors will switch out of preferred maturity
segments if premiums are adequate

CAPITALIZATION OF
INCOME METHOD
• INTRINSIC VALUE
– In equation form
n
ct
V  
t 1 (1  y ) t

CAPITALIZATION OF
INCOME METHOD
• SOLVING FOR V,
– Given the current market price (P), the
investment decision is
• if V is the intrinsic value and
V>P buy the bond

V<P don’t buy

BOND ATTRIBUTES
• SIX ATTRIBUTES that affect a bonds
value
– LENGTH OF TIME TO MATURITY
– COUPON RATE
– CALL PROVISIONS
– TAX STATUS
– MARKETABILITY
– LIKELIHOOD OF DEFAULT

LENGTH OF TIME TO
MATURITY
• COUPON RATE AND LENGTH TO
MATURITY
– these attributes determine size and timing of
cash flow
– yield-to-maturity

CALL PROVISIONS
• CALL PROVISIONS
– DEFINITION: a provision in some bond
indentures that permits an issuer to retire some
or all of the bonds in a particular issue prior to
maturity date stated
– Issuer may find it advantageous to call existing
bond
• if market interest rate is lower
• replace existing bonds with lower rate bonds

TAX STRUCTURE
• TAX STRUCTURE
– Taxation affects bond prices and yields
• low-coupon bonds selling at a discount provide
return in
– coupon payments
– gains from price appreciations
• taxes on appreciations may be deferred until bond
sale or maturity

MARKETABILITY
• MARKETABILITY
– refers to the ability of the investor to resell
– bid-ask spread is one indicator of marketability
• the higher the spread, the less marketable
• the lower the spread, the more marketable
– bonds that are actively traded should have a
lower YTM and a higher V

LIKELIHOOD OF DEFAULT
• LIKELILHOOD OF DEFAULT
– Bond ratings provided by professional services.
– Two most famous include
• Moody’s Investors Services, Inc.
• Standard & Poor’s Corporate ratings
– Categories
• investment grade usually the bonds in the top four
ratings
• speculative
• often called junk bonds

LIKELIHOOD OF DEFAULT
• LIKELILHOOD OF DEFAULT
– Bond ratings provided by professional services.
• better ratings are generally associated with
– smaller financial leverage
– larger firm size
– larger and steadier profits
– large cash flows
– lack of subordination to other debt series

Bond Pricing Relationships
• Inverse relationship between price and yield
• An increase in a bond’s yield to maturity
results in a smaller price decline than the
gain associated with a decrease in yield
• Long-term bonds tend to be more price
sensitive than short-term bonds

Bond Pricing Relationships
(cont’d)
• As maturity increases, price sensitivity
increases at a decreasing rate
• Price sensitivity is inversely related to a
bond’s coupon rate
• Price sensitivity is inversely related to the
yield to maturity at which the bond is
selling

CONVEXITY
• CONVEXITY
– DEFINITION: a measure of the curvedness of the
price-yield relationship
– price and yield are inversely related but not in a linear
fashion (see graph)
– an increase in yield is associated with a drop in bond
price
– but the size of the change in price when yield rises is
smaller than the size of the price change when yield
falls
CONVEXITY
• THE PRICE-YIELD RELATIONSHIP
Price
YTM
Duration
• A measure of the effective maturity of a bond
• The weighted average of the times until each payment
is received, with the weights proportional to the
present value of the payment
• Duration is shorter than maturity for all bonds except
zero coupon bonds
• Duration is equal to maturity for zero coupon bonds

Duration: Calculation
t
w t  CF t (1  y ) Price
T
D   t w
t 1
t
CF t  Cash Flow for period t

Duration Calculation:
8% Time Payment PV of CF Weight C1 X
Bond years (10%) C4
.5 40 38.095 .0395 .0198
1 40 36.281 .0376 .0376
1.5 40 34.553 .0358 .0537
2.0 1040 855.611 .8871 1.7742
sum 964.540 1.000 1.8853

IMMUNIZATION
• DEFINITION: a bond portfolio
management technique which allows the
manager to be relatively certain of a given
promised cash stream

IMMUNIZATION
• HOW TO ACCOMPLISH
IMMUNIZAITON
– Duration of a portfolio of bonds
• equals the weighted average of the individual bond
durations in the portfolio
– Immunization
• calculate the duration of the promised outflows
• invest in a portfolio of bonds with identical
durations

IMMUNIZATION
• PROBLEMS WITH IMMUNIZATION
– default and call risk ignored
– multiple nonparallel shifts in a nonhorizontal
yield curve
– costly rebalancing ignored
– choosing from a wide range of candidate bond
portfolios is not very easy

ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Horizon Analysis
• simple holding period selected for analysis
• possible yield structures at the end of period are considered
• sensitivities to changes in key assumptions are estimated
– Contingent Immunization
• portfolio managed actively as long as favorable results are
obtained
• if unfavorable, then immunize the portfolio

ACTIVE MANAGEMENT
• TYPES OF ACTIVE MANAGEMENT
– Bond Swapping
• exchanging bonds to take advantage of superior ability to
predict yields
• Categories:
– substitution swap
– intermarket spread swap
– rate anticipation swap
– pure yield pickup swap
– INDEXATION
• the portfolio is formed to track a chosen index

EVALUATING THE
INVESTMENT PROCESS
Prof. John Cotter

INVESTMENT
MANAGEMENT FUNCTIONS
• FIVE STEP PROCEDURE:
– SETTING INVESTMENT POLICY
– PERFORMING SECURITY ANALYSIS
– CONSTRUCTING A PORTFOLIO
– REVISING THE PORTFOLIO
– EVALUATING THE PORTFOLIO

INVESTMENT
• SETTING INVESTMENT POLICY
– DETERMINE THE INVESTMENT
OBJECTIVE
• estimate the client’s level of risk tolerance

INVESTMENT
• PERFORMING SECURITY ANALYSIS
– Security Selection: A 2 Stage Procedure
– STAGE I: forecast
• expected returns
• standard deviation
• covariances
• identify optimal portfolio

INVESTMENT
• PERFORMING SECURITY ANALYSIS
– Security Selection: A 2 Stage Procedure
– STAGE II: Asset Allocation
• strategic
– refers to how a portfolio’s funds would be divided, given
the manager’s long-term forecasts from Stage I
• tactical
– given short-term forecasts, who will assets be allocated at
any one time

REVISING THE PORTFOLIO
• REVISING THE PORTFOLIO
– Use Cost-Benefit Analysis
• transaction costs should be examined since they
complicate the management decision
• portfolio revisions must be weighed against the cost
of revision particularly with regard to transaction
costs

REVISING THE PORTFOLIO
• REVISING THE PORTFOLIO
– SWAP METHODOLOGY
• a cost saving method which involves exchanges of
asset rather than purchases or sales
• TYPES OF SWAPS:
– Equity
– Interest Rate

PORTFOLIO EVALUATION
• Complicated subject
• Theoretically correct measures are difficult to
construct
• Different statistics or measures are appropriate
for different types of investment decisions or
portfolios
• Many industry and academic measures are
different
• The nature of active management leads to
measurement problems

Prof. John Cotter Centre For Financial Markets (CFM) University College Dublin

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CORPORATE FINANCE

Prof. John Cotter

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HPR = Holding Period Return

HPR = ( 24 - 20 + 1 )/ ( 20) = 25%

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• Portfolio risk looks at the benefits of

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p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

Cov(r1r2) = Covariance of returns for

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p2 = w12  12 + w22  22 + 2W1W2 Cov(r1r2)

 p = [w12  12 + w22  22 + 2W1W2 Cov(r1r2)]1/2

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rp = W1r1 + W2r2 + W3r3

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– portfolio return (rp) is a random variable

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• Weak - Asset prices reflect all info from previous

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